Master Limited Partnerships: Peter Lynch's Yield Play

Book: Beating the Street by Peter Lynch with John Rothchild | ISBN: 978-0-671-75915-5

The phrase “limited partnership” makes most investors flinch. And honestly, they have good reason. Thousands of people got burned by tax-shelter schemes in the 1980s. Oil partnerships. Real estate partnerships. Movie partnerships. Even gravesite partnerships. The losses were worse than the taxes they were trying to avoid.

But Lynch says the good limited partnerships are getting punished for the sins of the bad ones. And that guilt by association is creating bargains.

What Are MLPs?

A master limited partnership is a company that trades on a stock exchange just like a regular stock. But it’s organized differently. The biggest difference is that an MLP distributes all its earnings to shareholders, either as dividends or as a return of capital. That means unusually high yields. Part of the annual payout is even exempt from federal tax.

The trade-off? Extra paperwork at tax time. You get special forms. The investor relations department fills in the blanks, so it’s not that bad. But it’s enough of a hassle to scare away most fund managers and big investors.

Lynch loves this. The less popular something is, the cheaper it stays. He says he’d fill out questionnaires written in Sanskrit if it kept MLPs unpopular and prices low.

More than 100 MLPs traded on stock exchanges at the time. They tend to be involved in normal, boring activities. The Boston Celtics was an MLP. ServiceMaster ran janitorial services. Cedar Fair ran amusement parks. EQK Green Acres owned a shopping mall on Long Island. These are not the kinds of companies that show up on CNBC.

EQK Green Acres: The Mall Play

After the Saddam Sell-off in 1990, EQK Green Acres dropped to $9.75. At that price, it had a 13.5 percent yield. That’s as good as some junk bonds, and Lynch thought it was safer.

The company’s main asset was a huge enclosed mall on Long Island. Only 450 such malls existed in the entire country. New ones were nearly impossible to build because of zoning problems and the difficulty of finding 92 empty acres for parking. So the competition wasn’t coming.

Lynch visited the mall. Bought a pair of shoes. The place was packed. Management owned a big chunk of the shares. The dividend had been raised every quarter since the company went public.

He recommended it in 1991. The stock went from $9.75 to $11, plus the dividend. That’s over 20 percent total return in one year.

But here’s where it gets interesting. When Lynch rechecked the story for 1992, he found warning signs. A lousy holiday season had depressed the rents. And the company broke its streak of raising dividends every quarter, over a single penny. That might sound tiny. But if a company that’s raised its dividend 13 quarters in a row stops over $100,000, Lynch suspected deeper problems.

He also noticed the company was negotiating with Sears and J.C. Penney for new space, but nothing was signed. Lynch’s rule: wait for the proof. A rumor isn’t a contract. He passed on recommending it a second time.

Cedar Fair: Roller Coasters and Dividends

Cedar Fair owns amusement parks. Cedar Point, on the Ohio shore of Lake Erie, has 10 different roller coasters, including Magnum (highest drop in the world) and Mean Streak (highest wooden coaster). The park has been around for 120 years. Seven U.S. presidents have visited. Knute Rockne reportedly invented the forward pass while working summer jobs there.

Lynch loved this business for a simple reason. Nobody is going to sneak up overnight and install $500 million worth of rides on Lake Erie. Unlike tech companies that can be wiped out by a competitor’s new product, an amusement park has a durable advantage.

He also figured that in a recession, the 6 million people living within three hours of Cedar Point might skip the trip to France and go ride roller coasters instead. This was a company that could actually benefit from an economic downturn.

In 1991, Cedar Fair stock rose from $11.50 to $18. Add in the dividend and shareholders got over 60 percent. But for 1992, Lynch called the president, Dick Kinzel. No major new rides were planned. Attendance usually drops the year after a big new ride opens. He liked Sun Distributors better.

Sun Distributors: Boring and Beautiful

Sun Distributors sells auto glass, sheet glass, fasteners, ball bearings, and hydraulic systems. The kind of company that puts business school graduates to sleep. Only one analyst even covered it, and she apparently stopped.

Point one in Sun’s favor: Wall Street was ignoring it.

The stock had two classes of shares. The Class B shares had fallen from $4 to $2. Lynch dug into the numbers and found a company making money every single year since 1986, even during a terrible recession. It had a 60 percent gross margin, tops among all distributors in its business. It needed almost no capital spending. And since 1986, it had bought 36 smaller companies and folded them in, cutting overhead and growing its market share.

The real story was cash flow. Because of all those acquisitions, Sun had $57 million in goodwill to write off. This accounting exercise made its reported earnings look half of what they actually were. The real cash flow was almost double the stated earnings.

When times got tough, management stopped making acquisitions and started paying down debt. Lynch saw that as a sign of smart leadership facing reality. Sun was the low-cost operator in a boring industry, and its competitors were falling away one by one.

Tenera: The Company with Warts

Tenera was Lynch’s riskiest MLP pick. The stock had crashed from $9 to $1.25. The company did software and consulting for nuclear power plants and government contractors. It was squabbling with the federal government over billing. Key executives had quit. The dividend was cut to zero.

So why touch it? Zero debt. Almost no expenses. And a nuclear services division that could be sold at a profit. Lynch figured even if the company never recovered, its parts were worth more than $1.50 a share.

If it solved some problems, big rebound. If it didn’t, small rebound. Either way, shareholders would likely get more than what they paid.

The MLP Lesson

Lynch’s approach to MLPs is the same as his approach to everything else. Look where nobody else is looking. Do the homework on the actual business. Check the balance sheet. And don’t let a complicated structure or extra paperwork scare you away from a good deal.

The high yields on MLPs existed because most investors couldn’t be bothered with the paperwork. That impatience was other people’s loss and Lynch’s gain.

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