Wednesday, March 31, 2010

What do Masters and Royals have in common?

It is hard to say if the dust has completely settled from the passage of the health care bill. Most of the provisions will not go into effect for some years to come if at all, depending on the outcome of the legal challenges and mid-term elections this year. Several companies have already decided to take significant losses now because of changes in the tax law and the tax treatment of their retirement health care plans. Deere and Company and Caterpillar just announced that they would take about $250 million in losses, which they say are related to the passage of the new law.

My clients know that over the last year I have been adding Master Limited Partnerships and Royalty Trusts to their accounts. Let’s discuss the reason why. These two structures are pass-through structures meaning that the income is generally taxed just once unlike a regular corporations, which pay taxes on earnings and then distributes dividends, which are taxed again to the investor.  TC Pipe Lines (TCLP) is a Master Limited Partnership, which operates natural gas pipelines in the mid-west and west. It sells for about $38 and has a dividend yield of just under 7.75%. We own this company because no matter how bad the economy gets people will still need natural gas to heat their homes and cook their food. TC Pipe Lines moves natural gas regardless of the price of natural gas and in turn we get paid for every cubic foot of natural gas that goes through their pipelines.

A Royalty Trust owns a percentage interest of natural gas or oil in the ground. We own Cross Timbers (CRT). We don’t speculate on where to find the natural gas and we don’t drill for it. We buy the reserves after they have been discovered and proven.  In the case of Cross Timbers we own 16 2/3% of every dollar of revenue derived by the sale of natural gas. The current yield for CRT is just under 6.75%. These are simpler structures than corporations and they pay excellent dividends, some at least for now, are tax-favored and may if fact increase in the future. In many of my accounts I have several MLP’s and Royalty Trusts to spread the risk around by region and commodity. If you’re thinking about these great income generators buy several. These investments are very defensive by nature and offer great current income potential. 

If we don’t put Americans back to work soon then the economy will grow at a sluggish pace and you will need cash flow to keep your money growing. With inflation at 2% and potentially increasing you need high current yield which Master Limited Partnerships and Royalty Trusts can give you.

Dan Perkins

Friday, March 19, 2010

I have been thinking, now I’m ready to write

The last posting was about the PIIGS economies where things are still not settled. I will continue to watch them, but we have a more important issue to deal with at the moment. In my opinion, this weekend may be the most important in the history of our nation—until the next piece of threatening legislations comes from the Congress. If the Speaker of the house has the votes, then the health care bill will be voted on in the house this Sunday. If they can’t get the votes by this weekend then support for the bill may wane and it may never come to a vote.

I have read many articles about the bill and the tactics used to get it passed. I do not know if the votes are there to pass the bill or not, but I do believe that if it passes there will be challenges in the courts as to the constitutionality of the law. An article in the Washington Post reports that the State of Virginia has already passed a law to file suite against the bill should it pass and goes on to report that an additional 36 states are considering similar laws.

There is no question in my mind that these lawsuits will get a fast track to the US Supreme Court, but even with a fast track it will take some time. I fully expect that the initial suits will seek an injunction against any implementation of the law until the courts deem the law constitutional.

There are thousands of pages in the bill and just as many provisions. I want to focus on a few provisions for now and discuss my prospective of their impact on the investor class.

First, let us look at what is supposed to be taxed. If you are currently retired and have no earned income then you are not paying the current Medicare supplement tax of 1.45%. A proposal in the Senate bill would increase the tax rate to 2.9% tax to include unearned income. This would mean dividends from stocks, interest earned on savings at banks and money market mutual funds and all forms of bonds including US Government bills, notes and bonds would be subject to this Medicare tax in addition to income taxes. This Medicare tax is favored by President Obama and many Congressional Democrats, but it is uncertain if this tax provision will reach the final bill.

Next we have Medicare payments, which under this legislation are scheduled to be reduced by $500 billion dollars. If the government is not going to pay then we will have to pay. If doctors will not accept Medicare payments then we will have to pay out of our pockets.

Now let me add to this the fact that the Bush tax changes will expire at the end of the year if the Congress does nothing to retain them. My guess is that they will expire and Congress will not extend them because they will want the increased tax revenue. The result will be higher income and capital gains taxes for 2011 and going forward for both sources.

I do not think the stock markets and businesses of all sizes will like the cost implications of this bill. If this bill passes, the cost of healthcare insurance for businesses will skyrocket. I pay $14,000 per year in healthcare insurance for my wife and I and have no idea what it will cost me for this coverage next year and beyond except I believe it will cost more. 

I have said to you many times that the recovery in our economy is about jobs and housing. The new healthcare bill will increase the cost of taxes and benefits to the business and in turn business will think very hard about hiring new employees when they look at the total cost of new employees. Homeowners with increased heath insurance costs may well have to default on the mortgage payment to pay the healthcare insurance premiums.

I think my approach of being paid while we wait will become even more important going forward. It is true that there is a possibility that dividends may be taxed more than they are now, but any yield above 5% will look very attractive even after tax. Those of you who are my clients know that I have been adding new income elements to your portfolios. We have been buying Master Limited Partnerships and Royalty Trusts. The next blog will go into more detail as to why I want to own these investments now and for the future regardless of the passage of the bill.

I expect the stock markets to increase in volatility over the balance of the year. The markets will most likely sell off next week if the bill passes this weekend. The big selling pressure will come towards year-end if it appears that the Bush tax laws will be left to expire. With higher capital gains taxes in 2011 people will want to take their gains in 2010, if they have any by then, at more favorable tax rates. It is possible that uncertainty about the tax laws may accelerate the selling before year-end.

Could we go back and test the march 9th lows? I do not think so, but we could give up 25% to 30% of the gain off the March 2009 lows. Finally, if this bill passes, even with all the possible changes don’t expect to see significant changes in unemployment. In fact if it does pass I expect by year-end companies will not be hiring, but may well be increasing layoffs and the unemployment rate will rise.

Dan Perkins