Don't Chase These 20% Returns

My good friend and fellow Fool Jesse Keyser and I share an obsession.  

Our passion is for classic so-bad-they're-fantastic movies. One instance of this is the 1988 action hit Die Hard. In this flick, terrorist Hans Gruber takes over Nakatomi Plaza in order to steal $640 million of bearer bonds. Hans (played by Alan Rickman) has several great quotes, but one stands out for us:

When they touch down, we'll blow the roof, they'll spend a month sifting through rubble, and by the time they figure out what went wrong, we'll be sitting on a beach, earning 20 percent.

Other than the whole rubble and blowing the roof part, Hans and I share a common goal: earning consistent income in a life of luxury.

But is this possible for individuals, short of a life of crime? Let's find out!

There are dozens of publicly traded stocks with dividend yields greater than 10%, but you shouldn't rush out and buy them just because you want to be like Hans. You may earn a sky-high yield for a quarter or even a couple of years, but it's really for naught if your principle declines over time or if the dividend is cut. This could be because of shakiness in the underlying business or an unsustainable dividend yield.

Some of the highest yielders in the market right now are mortgage REITs. They earn their money on the spread between low-interest short-term borrowing and purchasing high-interest long-term securities. Since borrowing is essentially costless in this environment, that makes this spread massive.

This combined with the fact that REITs are required to pay out at least 90% of their taxable income gives them some of the largest dividends the market.  

Here are some of the more popular, highest-yielding mortgage REITs on Fool.com:

Company

Recent Yield

Founding Date

Chimera Investment (NYSE: CIM  )

17.7%

2007

American Capital Agency (Nasdaq: AGNC  )

20.4%

2008

Cypress Sharpridge Investments (NYSE: CYS  )

17.9%

2006

Hatteras Financial (NYSE: HTS  )

15.2%

2007

These yields are unbelievably sexy when you compare them to the S&P 500 average yield of 1.91%.

But there are two things you should know before investing in them:

  1. Their yield comes with a large amount of risk. The first sign of meaningful inflation will likely cause the Fed to raise rates, if not sooner. This tightening will lessen the spread and ultimately damage the payout.
  2. They have all been in existence for less than five years.  Some, like Chimera, are spin-offs, but have still yet to establish any meaningful track-record. If you are going to pick one of the high-flying REITs, consider buying Annaly Capital Management (NYSE: NLY  ) as Fool analyst Ilan Moscovitz did in our 11 O'Clock Stock series.  It has been paying out dividends since 1997, which at least gives you some history to research. But it still suffers from risk No. 1, which makes it a non-investment for my money.

A better way
It's not that these stocks are necessarily bad investments, but their futures are a bit more uncertain due to interest rate exposure and federal legislations. However, if you share Hans' and my dream, you need to find great stocks that can outperform the market in addition to having great yields, and those that have the track-record to establish their longer-term viability. It's equally critical that you focus on the sustainability of their dividends.

To that end, The Motley Fool has created a new, free report titled 13 High-Yielding Stocks to Buy Today. I've selected two stocks from that report to discuss today, both of which have long histories of safe dividends.

First up, McDonald's (NYSE: MCD  ) .  While its current yield of 3.2% might seem paltry compared to the REITs above, investors should keep in mind that over the past 10 years, its dividend has increased by a compounded 46.1% per year.  Here is its 10-year chart, with the share price adjusted for dividends.

Total returns of 226% in 10 years? In network TV-style audio editing, Hans would be shouting "Yippie-kay-yay Motley Fool" at returns like that. With their payout ratio of at a healthy 48%, I feel great about their dividends lasting for the foreseeable future, regardless of a change in interest rates.

Next up, let's take a look at industrial equipment provider Emerson Electric (NYSE: EMR  ) , which pays a 2.5% dividend. Check out its 10-year dividend-adjusted returns.

Again, with a payout ratio of 52% and a 10-year compounded dividend growth rate of 6.7%, Emerson should deliver great returns at the right amount of predictability and risk.

Remember, these are just two of the 13 High-Yielding Stocks to Buy Today. If you'd like free access to the remaining 11, simply click here now.

True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.

Jeremy Phillips owns no shares of the companies mentioned in this article. Emerson Electric is a Motley Fool Income Investor choice. The Fool owns shares of Annaly Capital Management. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.


Read/Post Comments (16) | Recommend This Article (36)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 13, 2010, at 4:36 PM, EllenBrandtPhD wrote:

    CIM's management is experienced and astute. They do not raise their dividend by 6 percent in a lighthearted, frivolous fashion.

    Most have - correctly, I believe - interpreted the dividend jump two weeks ago to mean that earnings, in about another two weeks, will nicely beat consensus.

    While 5 of the 9 analysts covering the stock are at Strong Buy, 1 is at Buy and 3 at Hold. So there is plenty of room for Upgrades on or before that potential beat.

    It has been extremely worthwhile holding CIM exclusively for the dividends. But I do believe we are also about to see some very nice stock price appreciation.

  • Report this Comment On October 13, 2010, at 8:02 PM, NCRICK wrote:

    CIM and NLY and others are reaping the rewards of uber low interest and intvesting in market rate insured mortgages. They must pay 90% to stockholder hence the return. I own NLY and others REITS and am happy to collect the dividends but I watch it like a hawk and have stops to protect my investment. I think these stocks are good for at least a year. Move the stops and enjoy the income.

  • Report this Comment On October 13, 2010, at 9:47 PM, toddleem wrote:

    Bulls on these stocks should also note that prepayments hurt spread income. Fortunately, the prepayments have not arrived since very few homeowners have equity to refinance. Bulls should note that any large government program to help folks refinance at 4.5 percent will also hurt these stocks.

    Spread businesses rarely last.

  • Report this Comment On October 14, 2010, at 10:32 AM, nontechie wrote:

    When it comes to these mortgage REITS, I make a distinction between those in which Mike Farrell has a hand and those in which he doesn't. He has run Annally with great success through one of the most dramatic economic cycles in US history now. And he created Chimera specifically to take advantage of that cycle. Chimera doesn't have a track record because Farrell saw the opportunities in some mortgage bond babies being thrown out with the bathwater over the last couple of years and wanted to scoop them up. His success at Annally convinces me that if a regular retail investor like myself has any chance to profit from the recent chaos, it's with Mike charting the course.

    Obviously, then Chimera (and Annally both in this environment) must be considered a speculation for a smallish chunk of anybody's assets, but it is a speculation with a good reason to expect success and I think you are being "foolish" lumping it together with more pedestrian mortgage REITS.

  • Report this Comment On October 14, 2010, at 10:42 AM, nontechie wrote:

    PS: I agree with just about everything said above by others except the use of stops. In the era of the "flash crash", I don't trust stops any more. I keep my stop orders in my head these days (and sometimes I keep a few "severe lowball" bids listed at my broker).

    There will certainly come a time when the "spread business" doesn't work--even Annally got cut more or less in half at one point. But 2 years ago I thought that time would be now or sooner and here we are--it's still a great business. You DO have to watch these stocks like a hawk but so far their profitability has lasted longer than most people imagined and I suspect it may continue longer than anybody thinks now.

    By the way, my largest position for over a decade has been in Emerson so I recognize you do have a point.

  • Report this Comment On October 14, 2010, at 11:00 AM, scm68gt wrote:

    What a bunch of crap. Why shouldn't we, as the peedons by Wall Street, take advantage of the current market conditions - just like they do? Yes, if you are too lazy to manage your money, your shouldn't be in this arena. But if you are cautious, maintain your vigilance and don't get 'emotionally' attached to a particular stock, REITs and MLPs are great place to enjoy the current market.

  • Report this Comment On October 14, 2010, at 2:29 PM, wsplitts2 wrote:

    Just another attempt to sell their junky reports. Motley Fool has lost all respect they may have once had. You can get the same or better information for free.

  • Report this Comment On October 15, 2010, at 10:52 AM, tilka wrote:

    Does anyone else find it odd that these guys ran 4 articles in 10 days ripping on all REITS except Annaly?

  • Report this Comment On October 15, 2010, at 1:05 PM, tbstheman wrote:

    Mike Farrell has the "genius" of having many hedge fund managers as friends. When NLY had to cut their dividend years back, his friends did not attack the company - and made sure no one else did - and cut off NLY's access to capital. It's a good "strategy" to have. NLY is managed no better or worse than the current crop the fool is reviewing. One does have to wonder why they are pumping NLY so much recently and bashing the others.

  • Report this Comment On October 16, 2010, at 4:15 PM, woo131 wrote:

    I am very happy to earn these big dividends. I watch the economy like a hawk. I don't feel there will be a big (or much of any) boost in interest rates soon, so the risk is minimal. I don't find this article to be especially helpful or full of new thoughts.

  • Report this Comment On October 18, 2010, at 7:57 AM, pork7mm wrote:

    One missing thought is that many of these also invest in ARMs which will feature increasing yields along with the fact that they will continually be investing cash in the new securities that are increasing in yield. Thus, between increasing repo rates and increasing yields on securities, they should be able to maintain the spread. Combine that with the leverage and you'll still get good yields.

  • Report this Comment On October 18, 2010, at 7:30 PM, dbackroyal wrote:

    All the above are good comments and really help me. I guess I am smarter than what I thought. I bought these 6 months ago and with capital appreciation and yeild I am up 23%, not bad. Thanks people, I really enjot smart people like you telling me I am not stipid chasing after these yeilds. I now know when to get out and i will put a stop under them.

  • Report this Comment On October 20, 2010, at 6:18 PM, smacfe wrote:

    The dividend component to the returns on MCD and EMR are negligable. A dividend yield of 2.5% with 6.7% compounded dividend growth will take 12 years just to reach 5%. Don't try to jump on the dividend bandwagon unless you really understand what it takes to be a dividend/yield oriented investor producing minimally acceptable returns.

  • Report this Comment On November 04, 2010, at 11:23 PM, jm7700229 wrote:

    Overlooked, I think, is the fact that the market is pricing these REITs for their risk -- otherwise the yields would be much smaller. I don't believe the risk to principal is as great as others in this post do for that reason. I have some of my money in a couple of these because the return is excellent. The absolute earnings will lag considerably a rise in interest rates, and with interest rate risk priced in, I believe there will be plenty of time to adjust for future falls in market value.

  • Report this Comment On November 05, 2010, at 1:05 PM, MegaEurope wrote:

    I think Hans' plan was not very good. He should launder and relaunder the bonds into other assets as quickly as possible. Presumably the bonds have serial numbers and eventually the authorities will find the paper trail.

  • Report this Comment On June 15, 2011, at 8:48 PM, pryan37bb wrote:

    Hans could probably get 20% from AGNC, but he'll have to work harder than just buy-and-hold investors, since AGNC looks like it tanks every time it goes ex-dividend. Maybe if he also wrote some nicely-timed quarterly covered calls, he wouldn't feel the need to rob Bruce Willis' wife's building.

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