Today I'm going to give you some straight-talk about dividends.
High yield does not equal high return, and you could severely limit your returns if you don't heed this warning. In the next four minutes, allow me to explain what I believe is the wrong way to invest in dividends. I will also reveal the single best dividend stock I know.
You demanded it
With Treasuries and bonds paying bupkis, Fool.com readers have shown an increasing amount of interest in dividend-paying stocks over the past six months, and we are doing our best to cover them from every angle. Because of this interest, I pored through The Fool's vast databases to look for my and Fool.com readers' favorite dividend stock.
There's been especially huge interest in rural telecoms as they are among the biggest yielders in the S&P 500.
Last Dividend Payment Date
|Frontier Communications (NYSE: FTR )||8.3%||9/30/2010|
|CenturyLink (NYSE: CTL )||6.9%||9/20/2010|
|Windstream (Nasdaq: WIN )||7.7%||10/15/2010|
Compared to the S&P's yield of 1.91%, it's easy to see why investors are drawn to these stocks. However, smart investors look beyond the yield and into the growth prospects of the underlying company.
Rural telecom is a declining industry, and as a result, the underlying businesses are unlikely to grow -- other than through acquisition. For example, Frontier spent $5.25 billion on Verizon's (NYSE: VZ ) rural lines, and CenturyLink has recently agreed to merge with Qwest.
Sky-high yields of 8% may seem like a sure-fire win, but let's break it down. This industry is not growing, which implies that your original investment will not grow. If that holds true, it means that the maximum return you can expect is the yield itself, or around 8% per year for the companies above.
That's a decent return, but what if the industry declines? If you're taking the dividends as cash rather than reinvesting, you'll need around 12 years to double your money.
Consider that the Internet was in its infancy 12 years ago, and you'll see that a lot can change in communication over that time period. Over the next 12 years, your original investment is at risk of declining with the industry. If it does, then those 8% returns get wiped out very quickly.
Fasten your seatbelt for REALLY high yielders
The next category of high-interest dividend stocks are real estate investment trusts or REITs. Their business model is relatively simple: Borrow low-interest short term cash and use it to purchase long-term real estate-based assets. This is highly lucrative in the current environment given that borrowing costs are essentially zero.
In order to maintain a REIT status, these companies are required to pay out 90% of their taxable income as a dividend. That requirement combined with the huge spread between borrowing costs and their return equates to some very sexy dividends for investors.
This industry doesn't suffer from the same declining concerns as rural telecom, but there is something else investors should keep an eye on. As soon as the Fed begins bumping rates up -- and they will -- borrowing costs for these REITs will increase accordingly. When that happens, the spread will decrease, and ultimately their dividend yield will drop.
There will likely be some long-term outperformers in the group, as Annaly has been for more than a decade, but it's crucial that investors research the underlying company to look for operational advantages, rather than buying simply because of a high yield.
Medium yield, sky-high returns
That thinking leads to the company I believe is the greatest dividend payer in the market today. It is the leader in an industry that is essentially guaranteed to be around 100 years from now. While the industry may change, I believe this company has positioned itself to change with it. That's the kind of advantage dividend investors should demand.
I'm talking about Waste Management (NYSE: WM ) , the $16 billion leader in waste and environmental services. Including dividends, the company has returned 34% versus the S&P 500's 7% over the past five years.
More on the dividend in a second, but here are three primary reasons I like the underlying company and its industry:
- Trash is an everyday reality. My apartment in Alexandria, Va., scraps 10 dumpster-loads every single day, and I'm just one in a sea of buildings. There are few catalysts that could halt this daily process repeated thousands of times across America.
- Waste Management is North America's largest recycler. By 2020, the company expects to manage more than 20 million tons of recyclable commodities. I strongly believe that positions the company to benefit from a wider-spread green movement, which is almost a certainty in my opinion.
- They are innovators within a seemingly dirty and boring industry. From powering their trucks with liquefied landfill natural gas to creating Bagster, a heavy-duty portable "dumpster in a bag" targeted directly at consumers, the company is constantly looking for efficiencies and creating new realities in their industry.
For these reasons, even if they didn't pay a dividend, I like the company over the long-term. That's the crucial step I believe investors need to take before buying a dividend stock -- look at the company, then dig into the dividend -- not the other way around.
Combine this great business with a solid 3.6% yield and a five-year history of boosting its dividend by a compounded 9.3% per year, and you have a great addition for any portfolio.
While I truly believe Waste Management is the very best dividend stock in the market, intelligent investors demand more options for their hard-earned investing dollars. Thousands have requested access to a special dividend report created by Motley Fool analysts, and I invite you to download it today at no cost to you. In this report, Fool analysts cover several more outstanding dividend-paying companies, including the stock Fool analyst Jim Royal calls the "dividend play of a lifetime." To get instant access to the names of these 13 high-yielders, click here – it's free.