Hit the High-Yield Jackpot

Stocks with high dividend yields can do wonders for a portfolio. If you buy shares of a company that pays 6%, 8%, or even 10% annually and get a capital gain, you're pretty much assured of beating the market.

The problem is that high yields also tend to be unreliable.

High-yield headaches
High-yield stocks are only worthwhile when investors receive the advertised return. As valuation luminary Aswath Damodaran told Fool co-founder Tom Gardner in a recent interview, "High dividend-yield stocks are [only] attractive if you can expect the company to keep paying those dividends."

How do Fools separate jackpots from time bombs? Cash. Is the company generating enough free cash flow (FCF) from operations to cover its dividend, or is it borrowing money or using one-time gains (such as selling assets) to meet obligations? If it's the latter, a cut could be in the making. Here are three companies currently paying more than they earn:

As Tim Beyers pointed out recently, GM is a disaster waiting to happen. The company continues to pay shareholders even though it is not making money. While its cash hoard could support it for a bit, the advertised 10.6% yield is one investors would be smart to avoid.

The same can be said of recently public Reddy Ice. The company continues to pay dividends and post losses. But that may be coming to an end. The company wrote in a recent press release, "Reddy Ice intends to pay regular quarterly cash dividends pursuant to its dividend policy. However all subsequent dividends will be declared by the Board at its discretion."

High-yield opportunity
Motley Fool Income Investor -recommended real estate investment trust (REIT) AFR is a more interesting story, particularly since the REIT sector has seen yields decline as major players such as General Growth Properties (NYSE:GGP) have drastically outpaced the market. Since the company operates as a REIT, its payout is necessarily high. But when analyzing REITs, the key statistic is FFO (funds from operations), not FCF or net income. To calculate FFO, add back depreciation and amortization to net income -- a number that is often high since REITs deal in real estate. AFR has trailing-12-months FFO of approximately $90 million -- far less than it needs to cover the $140 million in dividend payments it is on the hook for in the coming year.

Can the company grow enough to cover that gap? Management seems to think so. They were adamant in a recent conference call that the dividend is not in danger, and the CEO and chairman have been buying shares recently. Most analysts and investors, however, seem to disagree. The stock price has dropped substantially since 2004 and now trades some 20% below the 2003 IPO price. That's why we have the outsized yield today.

The company is generating cash by selling non-core properties to enhance the reliable stream of income it receives from mostly A- or better credit-rated financial institution tenants. While skeptics doubt the long-term viability of the transactions, recent guidance shows that the company's FFO payout ratio in 2006 will only be 93%.

Foolish bottom line
AFR is not a clear-cut play. But if it were, the big yield wouldn't be there. See, yields decline as prices rise. A reliable 8% yield in an efficient market is like a wounded tuna to a shark -- it's not going to last very long.

You can always stick with the conservative and covered yields like the 1.4% yield and 27% payout offered by Microsoft (NASDAQ:MSFT), the 1.3% yield and 20% payout that's Wal-Mart's (NYSE:WMT), or even the 2.8% yield and 49% payout of General Electric (NYSE:GE), but the potential reward isn't as great as doing the due diligence on a company like American Financial. A 30-day free trial to Income Investor, on the other hand, will give you the inside track on the best and biggest yields the market has to offer, including two of the market's most overlooked REITs. The secret is cash and the cash can be yours. Click here to learn more.

Tim Hanson does not own shares of any company mentioned. Microsoft is a Motley Fool Inside Value recommendation. No Fool is too cool for disclosure ... and Tim's pretty darn cool.