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My Top Three Stock Picks for 2008

March 31, 2008 – by Richard Band

Instead of recapitulating what has now become a belabored list of market grievances, I have some information that might be of use primarily to income-oriented folks.

I want to point out one of the anomalies in the market today: Yields on certain high–quality income investments have remained quite generous, even with the Fed cutting interest rates.

This is particularly true for the tax-sheltered Master Limited Partnerships (MLP), which in some cases are paying well over 7%.

But before I get into three masters of the income universe, I want to clear up some of the misconceptions that lead investors to shy away from MLPs, and to reiterate why we here at Profitable Investing have such a soft spot in our portfolios for them.

Misunderstanding Cleared Up

In a previous issue of Profitable Investing, I did my best to lay two of the most common concerns about MLPs to rest:

1. MLPs bear little or no resemblance to the shady real estate or oil drilling limited partnerships that blew up in people’s faces during the 1980s.

The “master” in the name means that these partnerships are publicly traded, most often on the New York Stock Exchange. A public listing, in turn, puts management’s abilities and strategies under the microscope of the market every business day. If an MLP hopes to raise fresh capital (and most do, from time to time), management must produce results. The 1980s deals, by contrast, weren’t publicly traded, so there was no market accountability. They took your money once – and you were lucky if you ever saw it again.

2. MLPs can easily pay cash distributions in excess of their reported earnings.

Conscientious readers who like to double-check my research (something I welcome) often write me in this vein: “XYZ partnership is paying out $2 per share, but Barron’s says XYZ will only earn $1.50 this year. How can they sustain the distribution?”

Simple. Most MLPs (especially those that operate pipelines or other “heavy metal” businesses) generate cash flow well above their reported earnings.

Reason: Depreciation – which is deducted in computing an MLP’s earnings – is a bookkeeping entry that doesn’t actually consumer cash. As a result, the part of your quarterly distributions that exceeds reported earnings escapes current taxes. Eventually, when you sell your MLP units, the government will tax those deferred amounts as ordinary income. Also, if you hold your units long enough for the cumulative deferrals to equal the units’ original cost (maybe 10–13 years), you can’t defer tax on any subsequent distributions. Until either of those events occurs, though, you’ve got a wonderful source of tax-sheltered income.

How is an MLP a tax shelter?

Well, the fact of the matter is that a master limited partnership doesn’t have to pay any Federal income tax on its own; rather, it passes along all of the income and deductions to you, the limited partner. So, you get to take the partnership depreciation deduction just as the partnership would if it were filing the return.

As a result, a large portion of your cash payout is sheltered by this depreciation deduction. This is what you do as a limited partner; you don’t get those deductions if you own shares of a corporation.

Now let’s turn our attention to three masters of the MLP universe: Energy Transfer Partners (NYSE: ETP), Buckeye Partners (NYSE: BPL), and Enterprise Products Partners (NYSE: EPD). All three of these MLPs are pipelines that transport natural gas, oil and refined products. They’re all very stable, high-quality utility-like businesses, and these MLPs are trading at, as I say, yields of in some cases of 7% and more.

Stock #1: Energy Transfer Partners (NYSE: ETP)

One MLP that I’ve been buying rather heavily for my own account in recent days is Energy Transfer Partners. ETP owns a rapidly growing natural gas pipeline network as well as one of the nation’s largest propane-distribution businesses. It’s currently yielding over 7% and is growing faster than the typical pipeline partnership. We could be looking at annual increases in our cash payouts over the next 3 to 5 years of around seven or eight percent. ETP offers us an inflation-beating yield up front and a promise for yield increases coming forth over the next few years. I’m also expecting well over 90% of this year’s payout to be tax-deferred. Buy ETP, a member of our Incredible Dividend Machine, at $52 or less.

Stock #2: Buckeye Partners (NYSE: BPL)

Although ETP would be my number one pick, Buckeye Partners is a very conservative partnership that I’ve been buying for years. Buckeye Partners is a pipeline that transports refined petroleum products, including gasoline, jet fuel, diesel fuel and natural gas liquids, to name a few. I’ve been recommending it since 1990, so over the last eighteen years Profitable Investing subscribers have earned a tremendous return on BPL. This MLP is currently yielding over 7%. Even though it’s not growing quite as rapidly as ETP, BPL’s conservative management has led me to set this aside for my own retirement. We should also note that this MLP has increased its payout every quarter for 15 quarters in a row, a pattern that’s continued even through these volatile times. What action should you take now? Buy BPL at $52 or less.

Stock #3: Enterprise Products Partners (NYSE: EPD)

Enterprise Products Partners is another great utility-like MLP, and it’s growing faster than Buckeye. I would say EPD is probably the fastest growing energy pipeline. It parallels ETP in terms of growth, but it’s paying a higher yield, which is why I’m banging on the table for this one. This is a great pick for investors entering retirement because of its above-average growth. I may not retire for quite a while yet, but one of these days I’m going to need that added income, and it’s wonderful in the meantime to have a tax shelter. I recommend that you buy EPD for $32 or less.

Speaking of tax shelters, I’m sure by now you’re aware that there’s an election on the horizon. Now, I’m neither an expert, nor a pollster, but it sounds to me from what I’ve been reading and hearing on the political front that we may be looking at tax increases in 2009 or 2010 – tax increases on our investment income. If this is the case, you’ll be mighty glad that you own some MLPs that will shelter your tax distributions, acting as a hedge against 2009 and 2010.

Be sure to check the website, www.rband.com, for my latest updates on these companies as well as their current buy prices.

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