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When I think of the term "home run stock," my greed meter gets overheated.
I don't normally think of 20% returns, or 50% returns, or a double, or even a triple. I think of something on the order of magnitude of a 10-bagger.
But there's danger in explicitly stalking a 10-bagger. Many times, we are attracted to the upside potential of a stock only to be blindsided by the downside risk.
In an attempt to find a market-beating truce between upside potential and downside risk, let me propose combining two concepts -- the home run stock and the dividend stock.
What's a home run dividend stock?
A dividend stock doesn't normally elicit the visceral adrenaline rush of a home run stock, but it's a classic tortoise-and-hare phenomenon. The empirical evidence shows that dividend stocks have beaten nondividend payers historically.
My favorite explanation why is that dividend payers are at a point in their lifecycle where they are stable enough to promise some payback to their investors. Dividend investors may miss out on the young cash-hungry start-ups like Microsoft in the 1980s, but they also miss out on many of the story-stock, never-was companies that drag down returns.
Another benefit of a dividend is that it takes capital away from bonus-seeking managers who may otherwise waste it by chasing ill-conceived growth (e.g., diworsifying acquisitions, risky or low-return projects, ill-conceived expansions, etc.).
Because of the risk-mitigating qualities of a dividend, I'm willing to accept a lower upside potential on a "home run dividend stock" than a regular swing-for-the-fences home run stock. I'm looking for a solid, sustainable dividend that could help me generate a double or triple rather than a boom-or-bust play that could be a 10-bagger or could be bankruptcy.
Let's look at three options.
Option 1: The big yielders
Not all dividend stocks are boring. If you want an adrenaline rush, the biggest yielders out there exceed 10%.
When my colleague Dan Dzombak recently looked at the top 25 yielders, Hatteras Financial (NYSE: HTS ) and Anworth Mortgage Asset (NYSE: ANH ) each yielded close to 15% and were among the top seven yielders. That's notable because they have similar business models. They invest in mortgage-backed securities and make money on the interest rate spread between these securities and their borrowings. Spreads are historically high right now, so they're making a mint. And since they're real estate investment trusts, they have to distribute most of these profits to shareholders. Hence the stratospheric yields.
But do you know what's more notable than two similar companies making the top seven? That all seven top yielders employ this same business model.
For those hoping to generate an easy double over a few years by simply cashing the dividends, that's a little unsettling. Are all these companies just riding a rising tide that's sure to ebb? The obvious risk is that interest rate spreads decline. Further, these companies generally borrow over shorter terms than the assets they buy. That's dangerous because a cash squeeze can come quickly with short-term borrowing, especially when your longer-term assets fall precipitously in value. And especially when you're overleveraged. If you want an example, see Bear Stearns and Lehman Brothers.
This is an example of why James Early, the advisor of our dividend stock service, consistently warns that yields over 8% are frequently too good to be true.
Conclusion: If the model is resilient, this could be a home run dividend stock opportunity. But this investment is only for the very skilled.
Option 2: The sleepy giants
On the other end of the spectrum are the boring stocks people think of when they think of dividend stocks.
I own shares in ExxonMobil (NYSE: XOM ) , Microsoft, and Altria (NYSE: MO ) . They're all great dividend-paying companies that dominate their industries, and I'd argue that ExxonMobil in particular is a great pickup right now.
However, none of these are in the part of my portfolio that is targeting doubles and triples in the next few years.
Conclusion: To use a baseball analogy, these stocks are high on-base-percentage picks, but they lack power.
Option 3: Ignored bank stocks
It's this final option that has me salivating at the opportunity of unearthing a home run dividend stock.
Bank of America, Goldman Sachs, and the other big boys make all the news, but I'm more interested in the smaller banks.
Why? Because recent financial reform hit the big banks much harder than the smaller ones. Because the smaller banks offer simpler business models and balance sheets. Because the best small banks stick to taking deposits and making loans. And because it's a part of the market that isn't getting much coverage from analysts or the media.
While we can't analyze all the individual loans these small banks make, we can look for banks that trade cheaply (on a price-to-tangible-book and price-to-earnings basis), that have taken allowances to cover all their non-performing loans, and that are confident enough in their futures to maintain healthy dividends.
Huntington Bank (Nasdaq: HBAN ) and Synovus (NYSE: SNV ) are two banks that many of my readers are drooling over, but they don't pass my initial test. They aren't generating positive earnings, their dividends aren't that big, and they're a bit light in provisioning for bad loans.
One bank that does pass is Missouri-based Great Southern Bancorp (Nasdaq: GSBC ) . It has a low price-to-tangible-book ratio (1.2), enough earnings to have a P/E ratio of just 7.5, an ample allowance for bad loans, and a dividend yield of 3.3%.
But this is just an initial screen. You'll want to note that Great Southern still needs to repay $58 million in TARP money to the government, has a fair amount of construction loans, and relies on commercial lending for much of its loans.
Still, if you have the know-how to dive in, I think a portfolio of smaller banks is your best shot at finding home run dividend stocks. In fact, I do this in my own portfolio.
But like the high yielders we talked about earlier, bank stocks aren't for everyone. For some dividend opportunities that may better fit your investing style, click here to get The Motley Fool's five-page free report: 13 High-Yielding Stocks to Buy Today.