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Investing Specialists

Tactical Tips

StockInvestor editor Paul Larson offers up practical tips on stop-loss orders, shorting, lawless geographies, and MLPs.

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I’ve written extensively in the past about the strategy I am pursuing within Morningstar StockInvestor's Tortoise and Hare portfolios—focusing on wide-moat firms with high returns on capital that will compound their intrinsic values at above-average rates, and only buying when they trade at enough of a discount to our estimate of intrinsic value to provide a margin of safety. But these broad objectives don't mean I ignore the tactical details. Without further delay…

Stop-Loss Orders Make No Sense
On May 6, 2010, we experienced a “flash crash” that was like nothing modern markets have ever experienced. For instance, Tortoise Portfolio holding  Exelon (EXC) traded below a penny at the height of the craziness. Moreover,  Procter & Gamble (PG) went from roughly $62 to $40 in a matter of minutes, then popped back to $61 just as quickly as it had fallen. That drop represented about $70 billion of market value that was momentarily erased. That's a lot of toothpaste!

As I have mentioned to StockInvestor subscribers several times over the years, I generally disdain stop-loss orders, and I like them even less after this experience. I figure that if a company's intrinsic value is unchanged and its stock drops, say, 20% on no material news, I should be more attracted to the opportunity, not looking for the exits and selling at any price. In our overall system of evaluating companies and stocks—estimating an intrinsic value, then buying below that value—stop-loss orders simply make no logical sense.

The silver lining of the “flash crash” is that it illustrated how the markets have a very long way to go before becoming perfectly efficient. If anything, they may have actually become less efficient with the increase in high-frequency computerized trading. That’s great news for those of us trying to outwit Mr. Market.

Avoid Lawless Geographies
On more than a few occasions I have become aware of interesting opportunities in certain emerging markets that looked too good to be true. But no matter how dominant the business and/or inexpensive the stock appears, I think it is wise to avoid such situations if they are found under the auspices of governments that do not play by the normal rules of capitalism. Russia fits this description, as does Venezuela. Mainland China is also a borderline case; it has treated private companies relatively well thus far, but there are few checks and balances to the very strong central government.

The Hare’s experience with  CEMEX (CX) is instructive. In mid-2008, the company's assets in Venezuela were nationalized by the increasingly erratic and aggressive government of Hugo Chavez. This was not a fatal blow to CEMEX; these assets represented less than 5% of pre-nationalization production. But the timing was painful, coming at a moment when CEMEX could have really used the cash flow to ease the liquidity crunch it experienced at the height of the credit crisis. And it's worth noting that if the Venezuelan unit had been 50% of CEMEX, the terms of nationalization probably would have been no different, but it could have sunk the firm.

I also have an interesting personal story. Back in 2002 I found what I thought was a very compelling opportunity in a Russian company named Yukos. It was at the time one of the largest producers of oil in Russia (a non-OPEC country), its production was growing rapidly (15%–20% annual growth rates), and it had a management team that was improving efficiency and bringing itself up to Western financial standards by increasing disclosure. Yet the most attractive part was that the company was exceptionally cheap by just about any standardized measure; it traded at just 4 times earnings and a small fraction of production and reserves-per-barrel that the Western oil companies did. And this was back when oil prices were below $30 per barrel, too! Between oil prices starting to rise and the “Russian discount” starting to fade, my investment quickly tripled and was poised for even more gains.

Unfortunately, the company’s billionaire CEO, Mikhail Khodorkovsky, became a little bit too Western focused. In 2003, he started to criticize some of the Putin administration’s policies and began funding opposition parties in elections. Uh oh. The administration responded by claiming that Yukos had failed to pay sufficient taxes. Instead of playing along, Yukos fought back and proclaimed its innocence. Yet every time Yukos tried to defend itself, the bill for back taxes grew exponentially and arbitrarily. Meanwhile, the Russian populace did not exactly shed a tear for the demise of a major private company and its oligarch. The story ends with Yukos having all of its assets essentially seized by the Russian government and handed over to politically connected Rosneft for a song. For his part, Khodorkovsky has spent the past decade in jail.

I saw the writing on the wall and sold my shares before the end of the saga, but not before giving back all my gains. This experience seared into my brain the importance of having a solid rule of law behind any investment thesis. Without it, even the best fundamental analysis is moot.

Short Only With Options
Years ago in the “dot com” era, I used to sell stocks short (borrowing shares and selling first, then buying the shares back later to repay the loan) in my personal accounts quite often and with success. But I no longer short stocks outright, for two reasons. First, it occurred to me that over very long periods of time, stock prices tend to go up, and I’d much rather go with this tide than against it. Second, and more critically, if one makes a mistake in shorting, there are potentially infinite losses. I have made plenty of mistakes, and I know I will continue to make them; being wrong on occasion is an inherent part of investing. But while the most I can lose on a bad purchase is 100% of my original outlay, the potential to lose several multiples of my maximum potential gain on a short position just does not seem like a good proposition. After all, successful investing is very much about avoiding big mistakes, and ordinary mistakes can quickly explode into huge ones when shorting.

That said, I do still bet against individual companies in my personal accounts. (I often share some of my ideas in the “Stocks to Sell” column in StockInvestor.) The main reason I make modest investments on the “dark side” is because I think it makes me a more holistic investor. When I look at a company, I find that I do a less-biased analysis if one of the potential actions at the end is to bet against the stock. Going in with just a “buy/don’t buy” set of potential actions may bias me toward buying, if for no other reason than to try to get something out of the sunk cost reflected in the time I spent analyzing the situation.

Yet if my potential actions are “buy/no action/short,” I find I am much more balanced in my judgment. But it is worth noting that when I say “short,” as I mentioned, I don’t actually short the stocks. These days I exclusively make my bearish bets via put options. I try to buy options with as long an expiration as possible and only in very modest amounts. These options frequently expire worthless, but occasionally double or more in value. Most importantly, none of these individual options have the potential to completely destroy my portfolio.

Keep MLPs in Taxable Accounts
I have periodically purchased MLPs (master limited partnerships) in the Hare Portfolio, and I own a few at the moment, including  Magellan Midstream Partners (MMP) and  Enterprise Products Partners LP (EPD). There are also a number of other MLPs in the Wide-Moat Watchlist in StockInvestor. The reason is that long-haul pipeline companies—many of which organize under the MLP structure—tend to have wide economic moats thanks to geographical reasons (rights-of-way are tough to come by) and a generally friendly regulatory structure.

These companies tend to not have sky-high returns on invested capital (low-teens ROICs are common), but the returns are relatively steady. In general, these have been wonderful investments that have added value to the portfolios’ performance.

But if one is going to buy an MLP, it does not make sense to purchase it in a qualified account such as an IRA or 401(k). Some background is perhaps helpful to explain why. These MLPs are not corporations with an ordinary structure. The partnerships do not pay corporate income tax, and the entity’s income tax liability flows through to individual partners, which would be us. There is no “double taxation” here, just a single layer. The amount of taxable income is different for every single partner and is dependent on the purchase price. This level of taxable income has no relation to the partnership distributions, which are usually quite hefty—witness Magellan and Enterprise, both yielding near 5% at this writing.

The vast majority of MLPs do not generate taxable income for their owners in the first few years after they are purchased. This is because of an accounting concept known as the “depreciation shield.” When one buys an MLP, one is actually buying a portion of the underlying assets of the MLP, and the value of those assets is written up to whatever the investor paid (as opposed to the partnership’s own historic cost). The cost basis of the assets are then depreciated over time, and the owners can deduct this noncash expense from income. I know this is all a bit complex, but rest assured we don’t have to do the accounting ourselves. MLPs send K1 forms after the end of the year that have all income and expenses broken out for each individual owner.

Remember, there is no direct link between quarterly partnership distributions and the income tax liability the partnership is generating for its owners. And again, for most MLPs, their owners incur no income in the first few years they are owned. The partnership distributions are considered a return of capital, and that return of capital is potentially recaptured as income only once one sells. But as long as one does not sell, we have a stream of cash distributions that generate little to no income in the eyes of the IRS. Sweet! And what income and related tax liability we do have is greatly deferred, and we all know that money today is worth more than money a few years from now. (And as a side-note, if one passes away while owning these, the value of the underlying assets is written up yet again at death, restarting the clock on the depreciation shield for one’s heirs.)

So, in a nutshell, the first reason to lean one’s MLP investments toward taxable accounts and away from qualified accounts is that these entities are tax-advantaged, and one would not want to give up these advantages by owning them in an account that would not benefit.

The second reason has to do with taxable income. After owning them a few years, the MLPs should start to generate taxable income for their owners. This income is considered to be unrelated business taxable income (UBTI). If one’s MLPs generate in excess of $1,000 worth of UBTI inside a qualified account, then the qualified account itself (not the account’s owner) must pay the tax on this income. Most people think that qualified accounts are automatically exempt from all taxation, but this is certainly not the case if one buys MLPs in those accounts.

Many investors see these complications with taxes, their eyes glaze over, and they move on to simpler investments. But for those willing to do the extra legwork to understand how MLPs work (and fill out a small handful of extra forms come tax time), this investment class can create attractive opportunities, especially for those seeking a regular stream of cash from their portfolios.

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Paul Larson has a position in the following securities mentioned above: CX, EPD, MMP, PG. Find out about Morningstar’s editorial policies.