Rule No.1 for making money as an investor is not to lose your money in the first place.A certain well-known investor has taken this rule a step further by proclaiming that Rule No. 2 is not to forget Rule No. 1—no small trick in oil and gas.

Just think how pleased an investor is when attending an oil and gas company's corporate presentation, as its chief executive officer utters the phrase, “up and to the right,” to chart the path of robust and growing operating cash flows through time.The heart warms as Rule No. 1 seems happily in practice.But pleasure yields swiftly to dismay as the next slide depicts even more robust capital expenditures mopping up the entire supply of cash flow, as though the cash never existed to begin with.Rule No. 1 seems hopelessly unachievable.

Now unfolding is one man's answer to this common problem.James Murchie runs 10-year-old Energy Income Partners LLC (EIP), manager of $4.1 billion of capital invested in select master limited partnerships and utilities.Sitting in his office on the banks of the frozen Saugatuck River in Westport, Connecticut, Murchie delivers a stream of common-sense investment maxims grounded firmly in numbers and the historical backdrop of energy infrastructure assets over the past three decades.

Too many investors don't speak in numbers, Murchie says.The majority of them describe investments and capital spending outcomes with nouns and adjectives instead of actual quantitative measurements.This is a shot across the bow—don't be vague with this investor.

His investment philosophy stems from a decade spent first in business development for Sohio and BP, followed by a decade on Wall Street with Sanford Bernstein and Tiger Management.

He cites two separate epiphanies from the 1990s that now anchor his focus on MLP and utility investing.The first occurred in 1992 while he was attending an energy company's investor presentation in which the management identified a list of planned cap - ital projects in

descending order, from the highest expected return on capital to the lowest.Since that year had been a difficult one, the management regretfully noted that they couldn't fund those projects lower on the list.

Here was a light-bulb moment!By this company's own admission, the less cash management had available for reinvestment, the greater their average returns on that investment.In mature industries less is more—more capital discipline, that is.

Murchie quickly researched this concept and found it was a frequently recurring phenomenon.He compared the reported returns on equity of publicly traded oil and gas companies with the percentage of their operating cash flow reinvested, finding an 85% inverse correlation between the two.The more cash flow reinvested, the lower the return on capital employed.Conversely, the less cash flow reinvested, the higher the return.This explained why ExxonMobil persistently traded at higher price-to-earnings multiples than its smaller peers.ExxonMobil consistently reinvested the lowest percentage of its operating cash flow and earned the highest returns on capital employed, preferring to commit more cash to dividends and share repurchases instead of funding lower-return projects.And Mr. Market noticed.

The second epiphany occurred at 4 pm on the last day of the April 1997 Howard Weil Energy Conference in New Orleans.Most of the attendees had already hailed cabs for the airport, leaving Murchie and a handful of others struggling to stay awake, when Rich Kinder climbed to the podium.

Kinder had just formed an MLP to hold midstream assets.He explained that this structure would allow all the quarterly earnings from these assets to be paid directly to the owners, sort of like a family business.Sitting up straight and paying attention now, Murchie then heard Kinder say an MLP structure would impose greater capital discipline on management by forcing them to repeatedly justify growth plans to the investment community.Cash distributions would come from noncyclical, fee-based assets with low sustaining capital requirements and modest growth.

Moreover, unlike his former employer, Enron, Kinder saw neglected pipeline assets as debottlenecking opportunities instead of cost centers, and vowed to extract more value from these neglected assets.Here was the key to consistently applying Rule No. 1.

The Energy Income Partners investment model was thus born, though prematurely, as it turns out, since only a handful of energy-related MLPs were then available for investment: Kinder Morgan, Buckeye Pipeline, Kaneb Pipeline, Teppco, and an Enbridge predecessor, along with four propane MLPs.Moreover, electric utilities had just entered a deregulation-induced spending bacchanalia and were generally too enthralled with diversification into competitive or cyclical businesses to warrant serious, conservative investment.

Murchie likes the “utility model.” He prefers stable, slow-growth businesses with long-term assets having monopoly characteristics.Conservatism and an appreciation for historical context underpin his investment strategy.

There is a reason, he points out, why great companies have survived over long periods of time, companies like Coca Cola, Proctor & Gamble, and ExxonMobil.ExxonMobil, he says, tends to behave as though the next Great Depression lies just around the corner.

Great companies divide their cash flow into three categories.First, they commit to return cash to shareholders; second, they only fund those capital expenditures with a return on capital high enough to support dividend growth; and third, they leave the balance of their cash uncommitted as a cushion against adversity and to fund share buybacks, should they be so lucky.The MLP structure appeals to Murchie's conservative instincts, because he gets to receive all the cash flow, pre-tax.

Unpacking the usual list of objections to the MLP structure, Murchie rebuts each one, one by one, with numbers, facts and original research.Bam!It's like he is David Ortiz in the 2013 World Series.He can hit every pitch.His investment strategy is sound, and he has the quantitative data to back it up.

Growth via capital spending discipline

So how can MLPs grow?The answer lies in understanding how their assets previously did not grow.In the 1980s, tremendous latent value awaited deregulation of an overcapitalized pipeline asset base lacking growth incentives.Deregulation spurred changes in legacy pipeline asset ownership, and the MLP structure emerged in the late 1990s as a logical form to own mature, stable assets.

Real equity growth occurs specifically because of the capital spending discipline imposed by an MLP's high dividend obligation.And since the quarterly yield paid to MLP owners constitutes a large portion of their total return, MLP returns have inherently lower volatility.This allows the market to award MLPs a higher earnings multiple, and thus more flexibility for management to fund accretive capital spending projects with a lower cost of capital.

The higher multiple also incentivizes traditional C corps that own stable midstream assets to sell them to an MLP or to spin off partial ownership of them to their shareholders in the

form of a new MLP, thus unlocking more growth.This process has been ongoing for much of the past 15 years.

MLPs as an asset class have delivered impressive returns to investors.“The dividend is all an investor ever receives from a company,” Murchie says.Therefore, total return can be illustrated as the initial dividend yield plus growth in the dividend plus any change in valuation, up or down.MLPs delivered an impressive 15% total return, 6% greater than utilities, 6.4% greater than REITs and 7.6% greater than the S&P 500 over this 10-year period.

EIP's net pro forma SMA total return has exceeded the MLP Index by another 4.7%, clocking in at 19.7% over the 10-year period from January 2004 to December 2013.Murchie attributes this feat to his firm's conservatism, success in avoiding dividend cuts and practice of investing with higher quality management teams.

Reducing risk

Dividend disappointments loom as a large risk to MLP investors, especially in light of the burgeoning shale plays that require substantial new investment exposed to commodity price cycles and reserve risk.But that's a risk for C corps too.Murchie has a mantra on this subject.To wit, cyclical cash flows combined with too much leverage and a high dividend payout ratio have usually led to dividend cuts in the past, no matter what industry and no matter what the corporate structure.

That's why stock selection is critical.At its start 10 years ago, EIP owned about 20 energy-related MLPs of the 35 or so then in existence.Today it still owns 20 or so of them, even though there are now more than 100 MLPs and more on the way.Only a narrow set of companies actually fits the EIP criteria of 1) owning long-life assets generating stable cash flows and 2) being operated by a management team that can execute growth with the added challenge of maintaining investor confidence so they can raise additional capital.

Management selection is critical, too.Murchie cites pipeline construction experience as a key to good management.The chief executive of one MLP prominently represented in the EIP portfolio uses several tricks of the trade to manage capital costs, and Murchie cites a few of them off the top of his head, such as using multiple contractors on a project to quickly weed out and fire the big spenders.

Meanwhile, the chief executive of another MLP notably missing from the EIP portfolio has publicly reported surprise cost overruns that have throttled return on equity, and thus investor confidence.Management that cannot execute growth and maintain investor confidence will have trouble attracting the capital needed to fund growth and grow the dividend, which is the only thing a company gives you.Period.

What about interest rates?Many investors feel falling rates have provided a tailwind for MLPs and may present a future headwind when rates reverse direction and rise.This turns out to be a softball question, and Murchie knocks it out of the park.

He notes that the 10-year Treasury yield has fallen from about 4% to 3% over the 10-year period from January 2004 to December 2013.Yet the favorable change in valuation that accompanies this secular interest rate decline is only 1.7% out of 15% in annualized total return, a relatively small component.Moreover, he notes that utilities actually experienced a 0.5% decline in valuation over the same time period, thus refuting the notion that allegedly interest-rate-sensitive sectors, like utilities and MLPs, have benefited from falling rates.

But there's more.He has tracked quarterly MLP total return versus yields on the 10-year Treasury from 1996 to the present and demonstrated a slight negative correlation between the two (see graphic).In fact, these two analyses

Real equity growth occurs specifically because of the capital spending discipline imposed by an MLP's high dividend obligation.

demonstrate that the credit cycle is probably more important than the interest rate cycle, as a flight to safety into Treasuries during isolated credit events causes both a decline in rates and a decline in MLP total return.Removing these isolated data points from the analysis, he finds no correlation between interest rates and MLP total return.

Then there's the issue of incentive distribution rights, or IDRs, which the general partner of an MLP may hold as added incentive to grow distributions.These rights allow up to 50% of any increases in quarterly MLP distributions to flow to the general partner, and not the limited partner.

Some argue this is too high a reward for management doing its job.Here Murchie shares a seasoned perspective.First of all, MLPs don't pay taxes.If they did, investors would see a similar amount of cash flow lost to taxation.Furthermore, many of the general partners are now publicly traded, offering the limited partner the chance to buy and own the general partner too.This cancels out any negative effect of IDRs, with the added benefit of allowing an investor to participate in the more rapid growth that may occur at the general partner level.EIP owns both the general partner and the limited partner in several MLPs.

Finally, some MLPs have been spun out of C corp parent companies that retain the general partner and have real incentive to maintain and grow the limited partner through the contribution of additional midstream assets more efficiently developed with the lower MLP cost of capital.Therefore, IDRs serve as an incentive for this type of parent company support and a flow of growth opportunities so that limited partners can be assured of a reliable, growing income stream to support a low-teens total return.Nonetheless, IDRs do represent a kind of taxation for the limited partners.Consequently, the difference in this regard between a taxable pipeline or power utility and an MLP is less than most people think.

Going forward

When will the trend toward MLP ownership of midstream assets end?“Hard to say,” says Murchie.Many legacy pipeline assets still reside within C corps.Remember the Columbia Gas System?It's owned by NiSource, formerly known as Northern Indiana Public Service Co., an electric utility.

And remember the Consolidated Gas Pipeline System?That's owned by Dominion Resources.Both legacy pipeline assets traverse the Marcellus shale region, and both own valuable gas storage and related midstream businesses.Each has been rumored to be contemplating an MLP spin-off, and one has been rumored as a potential buyer of the other.

Similar spin-offs are occurring in the power sector.NRG Energy Inc. recently created NRG Yield to house its noncyclical assets with a 90%-plus payout ratio.With years of tax losses, NRG Yield looks like an MLP despite its C corp structure.And since power transmission assets now qualify for REIT tax treatment, NRG Yield may portend future transmission asset spin-offs by other diversified power utilities.

Avoiding commodity price and reserve risk, concentrating on stable assets with high dividend payout ratios, and knowing which management teams can husband precious capital and maintain investor confidence—these are the keys to superior investment returns using the MLP alternative.

The risk-averse strategy has many successful precedents.Howard Hughes sold drillbits to the wildcatters, Levi Strauss sold blue jeans to the miners, and John D. Rockefeller eschewed drilling risk, preferring instead to control transportation and refining.History has shown that risk avoidance pays off, and careful MLP investment selection appears to continue that trend.

Bill Weidner advises oil and gas company equity and debt holders and manages Energy Value Fund LLC.