A master limited partnership (MLP) issues equity units to finance growth. Its units immediately sell off on overblown fears of dilution, only to recover and move to higher highs in a matter of days or at most weeks.

That’s been the rule for MLPs–and in fact for most investments–since well before we started this advisory. And it’s likely to continue governing the way even the best trade for many months to come.

The new unit issue-selloff rule is a good reason why all investors need to adhere to our buy targets. Sure, it can be frustrating to wait on a particular MLP to dip back into a buying range. And it’s all too human to favor an investment that’s been rising in price over one that’s been lagging. But time and again we’ve seen these MLPs surge well above our recommended buy prices–which are based on fundamental business value–only to retreat again. It’s always better to be patient. In fact, it may be better to abandon a particular target entirely and go with a recommendation still trading below its buy price.

This week, it was Genesis Energy Partners LP (NYSE: GEL) taking its turn to sell equity. The MLP reported strong fourth-quarter and full-year earnings last month, supporting both the distribution increase announced in January and another that’s certain to come early next month. Distributions are up 9.1 percent over the past 12 months for the fee-based operator of crude oil infrastructure and services. And the payout has been hiked every quarter dating back to its August 2005 payment.

Nonetheless, when the MLP announced a secondary offering of 6.25 million of its units this week, with a provision to sell more on demand, its unit price plunged more than 6 percent in a single day. That took the units back to where they traded for most of February, setting up another buying opportunity in this solid MLP.

One reason why selloffs these days are so violent is investor distrust of markets in general. And the nature of Genesis Energy’s secondary offering–i.e. by what can legitimately be called insiders–is the type that always raises eyebrows. This is a sale by some of the MLP’s most intimate insiders. Denbury Resources (NYSE: DNR) had previously sold its general partner (GP) interest in Genesis Energy to Quintana Capital Group in December 2009. In this deal, it’s selling its entire limited partner interest, consisting of 4.1 million units. The rest of the offering consists of holdings by the MLP’s ruling Davison family, which currently holds 11.8 million of Genesis Energy’s 39.8 million outstanding units.

Of course, the Davison family will continue to own 9.4 million units after the sale, or nearly a quarter of the LP. And with the units more than doubling over the past 12 months, it’s natural they might want to take a profit. Meanwhile, the sale of Denbury’s stake has been expected since the sale of its GP interest, and Quintana shows no sign of losing its zeal for the MLP.

The bottom line is this is a far different thing from an outright cash-out by those in the know. And adding in Genesis Energy’s strong growth record and robust prospects for cash flow and distribution growth, we’re convinced the dip in the units is a buying opportunity, not a warning to cash out. Our buy target for Genesis Energy Partners LP remains 22 for those who don’t already own it.

The key is the numbers. If an MLP (or any other investment) is running a healthy business, its units are still likely to be volatile at times. We certainly saw that with the great meltdown of late 2008. That’s why you always have to observe buy targets when you add to positions and even be willing to take profits from time to time. That’s what we did with Williams Partners LP (NYSE: WPZ) after it more than doubled from our entry price in just a few months.

But as long as the underlying business is solid, any near-term setbacks in the unit price will be short-lived. Genesis Energy, for example, hasn’t yet fully bounced back from the dip it took this week. But the units have already stabilized, as patient buyers have begun replacing the skittish sellers. That’s the same pattern we’ve seen again and again with our picks over the past year, and we fully expect more of the same going forward.

The Right Numbers

Two questions we get a lot from readers are, No. 1, on what numbers do we base our business analysis, and No. 2, how do these numbers make us certain that technically related selloffs like Genesis Energy’s this week aren’t masking something deeper. Fortunately, there’s an easy answer and it’s demonstrated in the table “By the Numbers.”

Nothing in the markets is certain. As the selloff of late 2008 demonstrated, even money market funds’ safety can come into question under the wrong circumstances. We can certainly say what’s likely, what’s nearly certain, and what’s very unlikely. But to paraphrase Samuel Clemens–literature’s enigmatic Mark Twain–truth is stranger than fiction, and nowhere is that seem more often on a daily basis than the investment markets.

That’s why we always advise investors mix it up in their portfolios. Never fall in love with a particular stock or investment class. Even the best have vulnerabilities, and the only way to protect yourself is to spread your wealth among several. That way, a freak occurrence at one won’t sink you. As we saw in late 2006 when Canadian trusts sank in the wake of the taxation announcement, other investment groups often benefit from another’s demise. Those who held diversified portfolios of income investments in late 2006, for example, actually had rung up solid profits, as money exited trusts and bid up everything else.

When it comes to MLPs or any other tax-advantaged investment, the elephant in the room is always the US government. At this point, the Obama administration is an enthusiastic supporter of MLP advantages for energy-related entities. The Democrats in Washington, however, are ready to pull the plug on “carried interest” MLPs like AllianceBernstein Holding LP (NYSE: AB). AllianceBernstein and its ilk may indeed escape the knife, as Democrats appear unable to pass much these days. But we continue to recommend avoiding them for this risk, as well as the fact that yield-chaser investors seem completely heedless of the potential danger and valuations are paltry.

One thing the Canadian trust experience has taught us is that a strong underlying business will weather just about anything, from wrong-headed government actions to the worst recession and credit crunch in decades. We can’t always forecast every danger that lies ahead but we can always be prepared for it by ensuring our holdings stack up as businesses. And strong businesses always boost dividends faster, so we win even bigger when times get better, as they seem to be now.

 “By the Numbers” highlights the most important facts for MLPs, detailing why we’re so confident in our recommendations. Starting from the left, column two shows how well distributions are covered by each MLP’s distributable cash flow (DCF). As we’ve pointed out here numerous times, earnings per share (EPS) is a meaningless number for MLPs. In fact, management works hard to minimize it in order to avoid paying taxes, and the MLP structure gives it many ways to do that. As a result, EPS always understates the profitability of an MLP, just as it does for Canadian trusts, unit trusts, or any other entity that pays dividends from cash flow.

The better measure is DCF, which factors out all of the ways that MLPs minimize taxes, such as adding back in non-cash expenses and subtracting the impact of any one-time items. It also takes out maintenance capital expenditures, which are needed to run the business and maintain equipment.

The numbers presented in the table are calculated by dividing DCF for the past 12 months by the current indicated distribution rate. The result isn’t a percentage, which is the standard way to calculate payout ratios. Rather, if a company has a ratio of 1.2, it means that DCF is about 20 percent higher than the distribution. Generally, the higher the coverage ratio, the safer the distribution, though with the caveat that some businesses like producing energy have more volatile cash flows than for example a pipeline MLP.

These numbers are by no means perfect. They arguably understate the profitability of the energy producers in the Aggressive Holdings, which utilize a variety of hedging techniques to lock in cash flow. Also, the profitability ratio is a lagging number, while indicated distribution rates are leading. As a result, assuming the business plans the distributions are based on follow through, these coverage ratios will rise considerably in 2010. But they do provide a rough, conservative approximation of coverage, particularly if used in tandem with an analysis of each individual MLP’s strengths and weaknesses.

The next number is fee-based income as a percentage of overall income. True fee-based income isn’t directly impacted by changes in energy prices. Rather, it’s locked in with contracts and so is highly stable. The greater an MLP’s reliance on fee-based income, the more secure its distribution should be.

Note we haven’t included hedging undertaken by producers or contracts locking in revenue from volatile industries such as shipping. These do ensure income against ups and downs. But ultimately, contracts and hedges must be rolled over and the prices will depend heavily on where commodity prices are then.

Two good examples are producer Linn Energy LLC (NSDQ: LINE) and shipping company Navios Maritime Partners LP (NYSE: NMM). Both have essentially locked in their cash flow for 2010 with hedging and by fully contacting ships, respectively. But Navios Maritime will have to ink new contracts for 2011, and Linn will eventually have to put on more hedges. We’re optimistic for both. But what does happen will depend on commodity prices, and that’s a far different situation than what’s going on at Spectra Energy Partners LP (NYSE: SEP), for example, which is all fees and no commodity prices.

Credit raters are notorious for warning investors about pending market storms after they’ve already hit and billions of dollars of damage has been done. Credit ratings are, however, good gauges of what MLPs pay when they borrow money. And right now every investment grade-rated MLP is literally borrowing as much as it wants for peanuts.

Even Regency Energy Partners LP (NSDQ: RGNC)–which is involved in an aggressive shale infrastructure construction program–this month inked a $900 million credit agreement at a rate of just 2.5 to 3.25 percentage points above the London interbank rate. Ten-year notes issued by Enterprise Products Partners LP (NYSE: EPD), meanwhile, have a yield-to-maturity of just 4.873 percent. That’s barely 100 basis points above Treasuries.

Cheap credit and high unit prices mean well-capitalized MLPs have their best access to capital perhaps ever, even at a time where industry assets are still going cheap. That’s fuel for robust distribution growth for some time to come, and the better the rating the better the access.

Finally, the far right column shows dividend growth over the past 12 months. Given the extraordinary turbulence in the markets and the plunge in energy prices in particular, just holding distributions steady was an accomplishment. Any growth at all is extraordinary. Better, those rates should accelerate to the upside as 2010 progresses, and we’re looking for even energy producers to boost.

A quick glance at the table shows clearly that our picks stack up well on these numbers. We always want to know why a particular MLP may be up or down on a given day, and in fact we monitor our picks throughout the day. That’s our job. But as long as these numbers stay solid, we’ll stay confident, no matter what happens on a given day in the market.

We’ll still take profits when the situation warrants, no matter how strong the underlying MLP is. But strong numbers and unit price weakness are always a first rate signal for buying. And if you’re light in a security that never seems to trade below our buy price, they’re worth waiting on.

Last Reporter

EV Energy Partners LP (NSDQ: EVEP) became our final pick to report fourth-quarter and full-year 2009 profits this week. And those results were more than worth the wait.

Despite a year of weak natural gas prices (68 percent of output), the MLP boosted full-year cash flow by 11 percent and DCF by 10 percent, thanks to an 18 percent increased in production. Fourth-quarter numbers were more impressive still, with DCF soaring 42 percent from 2008, and 9 percent sequentially from the third quarter.

The key was a series of low-cost strategic acquisitions that added to reserves despite the impact of sharply lower natural gas prices. Reserves are now 70 percent gas, 18 percent natural gas liquids, and the remainder oil. Current plans call for ramping up natural gas liquids (NGL) and oil output in 2010 to take advantage of favorable pricing. Meanwhile, EV Energy remains one of the most hedged of all MLPs through 2014, which should enable it to weather weak conditions in the gas market.

The MLP also continues to make accretive acquisitions to boost production and reserves. This month it’s set to close a big one in the Appalachian Basin. And after an equity offering that will reduce debt, EV is well placed to make more deals in what management considers a “more favorable environment” for purchases in 2010. Support of parent EnerVest is another huge plus for financial strength, given its ability to raise money and organize profitable partnerships.

Unlike many exploration and production MLPs, EV Energy has consistently raised its distribution, boosting it every quarter since inception in early 2007. That’s a truly amazing record when one considers the ups and downs in energy prices, and it speaks to a long-term-minded management that doesn’t take chances with unitholders’ money. With conservatively measured fourth quarter DCF coverage of 1.3-to-1, it appears to be in good shape to keep distribution growth going in 2010.

The yield of roughly 9.5 percent is lower than it’s been in some time, owing mainly to the doubling in the unit price over the past year. But with its conservative financial plan and robust prospects for cash flow and distribution growth, EV Energy Partners LP is still a strong buy up to 32.