The MLP Profits Portfolios posted epic returns in 2009, as panic subsided and investors realized that the majority of master limited partnerships (MLP) had survived the credit crunch and plummeting commodity prices. Some of our favorite names even managed to grow their distributions in 2008, the height of the carnage. During this trying time, MLPs with the most perceived exposure to economic conditions posted the biggest declines in unit price.

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Source: Bloomberg, MLP Profits

In 2010 strengthening business fundamentals and distribution growth fueled another strong performance. Although a few laggards held us back in 2011, the overall Portfolio still trounced the S&P 500.

Source: Bloomberg, MLP Profits

Today, MLPs are still in the sweet spot: Not only does the nation face a critical shortage of midstream infrastructure to support growing output from prolific shale oil and gas plays, but most MLPs also have easy access to relatively inexpensive debt and capital.

Our favorite MLPs continue to grow their distributable cash flow through acquisitions and organic growth projects, but all our infrastructure-related picks secure commitments from customers before turning the first shovelful of earth for new pipelines, fractionators or gas processing facilities.

In late 2011, some investors fretted that a study linking water contamination to hydraulic fracturing in Pavilion, Wyo., would prompt the government to restrict the practice and derail the shale oil and gas revolution. Fracturing, or stimulation, increases the permeability of the reservoir rock, allowing the formerly trapped hydrocarbons to flow from the reserve rock into the well. This process involves pumping large quantities of water and a small percentage of chemicals into the rock formation at high pressure, which produces a network of cracks. This production technique is critical to unlocking oil and gas isolated in shale and other “tight” reservoir rocks.

In Sound and Fury, Elliot debunked speculation that the Environmental Protection Agency’s “smoking gun” would lead to restrictive regulations on hydraulic fracturing, explaining why the unique situation analyzed in the report had little bearing on activity in commercial-scale shale oil and gas plays.

President Barack Obama likewise put these fears to rest during his 2012 State of the Union address, highlighting the nation’s rising output of natural gas and encouraging its widespread adoption for power generation and transportation. Such an endorsement effectively rules out overly restrictive regulations that would curtail hydraulic fracturing.

Although the government may mandate the disclosure of the chemicals used in fracturing fluid, drilling should continue apace in the Eagle Ford Shale and the nation’s other major unconventional oil and gas plays. Spears & Associates, the preeminent provider of data on pressure pumping, estimates that global spending on this critical service will surge 23 percent in 2012, to $52 billion. Much of this spending will occur in North America.

Frenzied drilling activity in the Bakken Shale in North Dakota, the Eagle Ford Shale in South Texas and other oil-rich plays has enabled the US to grow it annual oil output for the first time in decades. Even more impressive, this increase in overall oil volumes has occurred despite a sharp decline in production offshore Alaska and in the Gulf of Mexico. 

Meanwhile, robust drilling in the nation’s shale plays also enabled the US to surpass Russia as the world’s leading producer of natural gas and has dramatically depressed gas prices in the closed North American market. Despite gas prices that continue to hover near record lows, US output has continued to grow. Exploration and production firms have shifted their emphasis from dry-gas fields to plays that also produce large amounts of higher-value natural gas liquids (NGL) that improve wellhead economics. 

This upsurge in onshore oil and gas output has occurred in the Bakken Shale and other regions that lack legacy takeaway and processing capacity, while even the Permian Basin in west Texas–an area that’s produced oil since the 1920s–requires additional infrastructure to handle growing volumes. With ready access to capital, MLPs will build much of this midstream capacity.

Despite these strong fundamentals, recent inflows into the MLP space have pushed valuations to frothy levels. We can’t emphasize enough the importance of adhering to our buy targets and taking some profits off the table when a big winner throws off the balance of your portfolio.

Some investors balk at taking some profits in MLP positions that have rallied considerably–after all, no one likes to pay taxes. If you hold your MLP investments in a taxable account, you’ll likely be paying on a cost basis that’s been reduced by accumulated distributions that count as a return of capital.

Investors should grit their teeth and remember that regardless of the tax you pay on your gains, you’ll reap more profit than if you lose some of your paper profits in a correction. Moreover, the 15 percent tax rate on long-term capital gains is the lowest in decades.

If you hold your MLPs in an IRA, taking some money off the table won’t trigger a taxable event. Nonetheless, some investors will rationalize their decision not to take profits by reminding themselves that they’re earning a higher return on their original investment than they could earn by investing new money. But a 10 percent correction in the market could more than wipe out a year’s worth of income from any MLP.

Don’t equate taking profits with bailing out. In these uncertain times, taking what the market gives you will lock in hard-won gains. You can always reinvest the proceeds when stock prices inevitably pull back.

Problem of Price

Despite economic uncertainty and the EU’s ongoing sovereign-debt crisis, a reprise of the financial meltdown and credit crunch of 2008 appears unlikely for the time being. Corporations can still borrow money at extraordinarily low rates, a stark contrast to the tightened credit conditions that prevailed in 2007 and 2008.

Most companies have taken advantage of the benign rate environment to extend near-dated bond maturities, a move that has limited their short-term credit needs. That being said, credit is the lifeblood that enables MLPs to acquire assets and invest in growth projects; an extended credit crunch could stunt distribution growth.

After the stock market swooned in two consecutive summers, investors should be prepared for equities to follow a similar pattern this year, particularly with the presidential election on the horizon and uncertainty regarding future tax policy. Unforeseen events such as the Arab Spring and the magnitude-9.0 earthquake that hit Japan in March could also shake up the stock market.

By and large, US equities weathered the storm in 2011, eking out a slight gain despite the breakneck volatility. The holdings in the MLP Profits Portfolios returned more than 7 percent in 2011, reflecting strong fundamentals and growing distributions.

However, MLPs face a new challenge in 2012: valuation. In the current environment, interest rates no longer drive stock prices for MLPs and other dividend-paying fare. In fact, MLPs frequently rally when the yield on the 10-year Treasury note increases and trade lower on days when this yield declines.

Like other dividend-paying equities, MLPs are following a different yield curve than in previous periods. Fear of inflation and rising interest rates has taken a back seat to investors’ perception of dividend sustainability. The greater the perceived risk of a dividend cut, the more selling pressure a stock will face. Safe havens, on the other hand, tend to attract buyers and have lower yields.

When fear rules the ticker, the yield curve steepens dramatically, widening the gulf between the yields on “riskier” and “safer” MLPs. When investors grow more optimistic and are willing to take on additional risk in exchange for higher yields, the curve flattens.

Of course, the market’s perception of risk doesn’t always reflect reality. Stocks that are in motion tend to stay in motion. That is, the market tends to pile into names that are appreciating in value because they assume these stocks entail less risk. The same principle applies on the downside: When an MLP’s unit price declines, investors assume that the risk of a distribution cut has increased, a perception that engenders even more selling.

Investors who focus on fundamentals rather than sentiment have ample opportunity to take advantage of the market’s inefficiencies. Conservative Portfolio holding Genesis Energy LP (NYSE: GEL), for example, returned 13 percent in 2011, less than half the gain posted by units of Kinder Morgan Energy Partners LP (NYSE: KMP). However, Genesis Energy grew its distribution by 10 percent in 2011, whereas Kinder Morgan Energy Partners increased its payout by only 2.6 percent

The difference-maker: The market regards Kinder Morgan Energy Partners’ distribution as far more secure than Genesis Energy’s payout. But higher payouts will drive price appreciation over the long term.

Units of the two ship owners in the model Portfolios, Navios Maritime Partners LP (NYSE: NMM) and Teekay LNG Partners LP (NYSE: TGP), both generated a loss for investors, despite raising their distributions by 2.3 percent and 10.1 percent, respectively. If not for powerful fourth-quarter rallies, both stocks would have finished 2011 deep in the red.

Fear of potential dividend cuts drove the stocks lower. None of Navios Maritime Partners and Teekay LNG Partners’ accomplishments–from hiking their payouts to locking in new vessels under attractive, long-term contracts–was enough to mollify fears that challenging conditions in seaborne shipping markets would eventually sink the stocks.

Both stocks have rallied considerably in 2012, likely because of Iran’s saber-rattling about closing off the Gulf of Hormuz. Not only is Iran unlikely to make good on its threat, but such a move would also have little effect on either company’s fortunes–Navios Maritime Partners owns a fleet of dry-bulk tankers, while Teekay LNG Partners focuses on vessels that transport liquefied natural gas.

But in a market where exchange-traded funds and products that offer one-stop exposure to a particular industry or sector, the correlation between stocks tends to increase.

As long as Navios Maritime Partners and Teekay LNG Partners continue to grow their cash flow and distributions, the market will eventually catch on. In the meantime, investors can take advantage of the shortsighted herds to lock in high yields and long-term capital gains. Navios Maritime Partners LP rates a buy up to 20, while Teekay LNG Partners LP rates a buy up to 41.

Funds Jump In

Taking advantage of mispricing and misperception of risk in the stock market is a major part of our 2012 strategy. Investments banks and asset management outfits have launched more than 23 MLP-focused funds over the past two years, while inflows from pension funds and other institutional investors have also increased.

Nevertheless, the investable universe of MLPs remains relatively small; this influx of liquidity will continue to drive prices higher. As you can see, almost all the holdings in our model Portfolios now have a healthy chunk of institutional ownership.

Source: Bloomberg, MLP Profits

Nevertheless, these percentages still lag those of other stock categories. For example, Southern Company (NYSE: SO), one of the larger members of the Dow Jones Utility Index, has institutional ownership of about 45.7 percent. That’s more that twice as much as Kinder Morgan Energy Partners, which has a slightly lower market capitalization.

There’s plenty of scope for institutional investment in MLPs to increase, though rules limit the opportunity for direct ownership. The proliferation of exchange-traded products that invest in MLPs provides backdoor exposure for these entities.

In the near term, MLPs remain widely held by individual investors, which can lead to some strange trading patterns. For example, units of Enterprise Products Partners LP inexplicably tumbled from their opening price of $40 to an intraday low of $27.85, before recovering to close near $40.

Much of this volatility likely stems from professional traders dumping a block of the stock in an effort to trigger stop-loss orders set by individual investor. The subsequent wave of selling propels the stock lower, allowing the investor to repurchase the units and book a sizable gain in a short period.

As we’ve noted time and again in MLP Profits, investors shouldn’t use stop-loss orders on their MLP holdings. Trailing stop-loss orders, which adjust upward as an MLP’s prices increases, are particularly dangerous.

Also, keep in mind that stop-losses don’t guarantee that your position will be liquidated at the designated price; these orders ensure that your stock will be sold as soon as possible after the units breach a certain threshold on the downside. In a volatile market, stop-loss orders are more likely to sell you out of good positions at bad prices.

Diligence and a diversified portfolio are your best tools for managing risk in your investment portfolio. When you remain confident in an MLP’s business prospects and ability to sustain and grow its distribution, short-term downdrafts represent a buying opportunity–in these instances, volatility is an investor’s best friend. (That being said, investors must also objectively evaluate their holdings and bail if the underlying business deteriorates materially.)

You should also consider placing buy-limit orders–which are executed when a stock declines to a preset price–on MLPs you’d like to add to your portfolios. Some readers who set buy-limit orders have been able to add high-quality names such as Enterprise Products Partners at dream prices.