3 Dangerous Dividend Stocks

What's the first emotion you feel upon seeing a high dividend yield: greed or fear?

For me, it's greed. I'm not going to deny it. I love dividends, and the bigger, the better. There's nothing like getting a check every few months simply for investing money that'd otherwise sit idle. It's like having your cake and eating it, too.

Yet it's exactly this type of impulsive thinking which leads to losses, as the emotion which should be triggered by high dividend yields is fear. Like any other type of yield, a dividend yield communicates risk. The higher the yield, the higher the risk. After combing the exchanges for examples, I settled on the three stocks below to demonstrate this point.

1. Hudson City Bancorp (Nasdaq: HCBK  )
Hudson City Bancorp is a New Jersey savings and loan institution yielding 5%. It's the second-largest publicly traded thrift in the country with $44 billion in assets. Its stock trades at a discount to book value, and according to its webpage the lender "has consistently been named The Most Efficient Bank in America."

With these particulars in mind, it's easy to understand why Hudson City's investor relations department would observe: "It's no wonder Forbes named Hudson City 'Among the Best-Managed Banks in America.'"

The only problem is that these accolades are four years old. In the intervening time period, the bank's rank and fiscal position have deteriorated markedly.

Category

2012

2011

2010

2009

2008

Forbes Rank * 64 17 13 1
Assets (billions) $44 $52 $61 $57 $47
Return on Assets (2.3%) (3.1%) 10.5% 10.0% 6.7%

Sources: Forbes' America's Best and Worst Banks and YCharts.com. *2012 rankings are expected later this year.

To add insult to injury, the bank has been operating under memorandums of understanding with both the Federal Reserve and the Office of the Comptroller of the Currency since the middle of last year. These understandings require Hudson City to rework the size and composition of its balance sheet and to obtain approval before "incurring any debt with maturity greater than one year ... declaring a dividend to shareholders ... or repurchasing ... Company stock." It's probably worth noting that these arrangements are often the kiss of death for both a bank's dividends and the underlying institution itself.

2. Annaly Capital Management (NYSE: NLY  )
Annaly Capital Management is the biggest and best-known publicly traded real estate investment trust specializing in mortgage-backed securities. While Annaly's stock yields a  ridiculous 13%, this figure is still less than the 15% yield of its fellow and operationally linked mREIT Chimera Investment (NYSE: CIM  ) -- though, as Rich Smith noted, Chimera ominously informed investors that it will be restating financials for the past three years.

If you're not familiar with this type of investment vehicle, it's helpful to think of mortgage REITs as hedge funds that arbitrage interest rates. A typical mREIT raises money by issuing stock, leveraging the proceeds in the short-term credit markets, and then buying longer-term, higher-yielding mortgage-backed securities with the resulting capital. The earnings derive from the spread between short- and long-term interest rates.

Two weeks ago, Annaly reported second-quarter EPS of $0.55, comfortably beating the consensus estimate of $0.48 and just enough to maintain its dividend of $0.55. Yet despite this beat, shares slid a few cents. The reason? As my colleague Rich Smith noted, "Not everyone is convinced that Annaly's beat was all that met the eye."

The problem is that approximately $0.10 of the company's earnings per share related to one-time gains from the sale of securities. Without these gains, according to an analyst at Nomura Securities, Annaly's dividend is "not sustainable ... and further dividend cuts are possible."

While Annaly has dealt with this problem in the past by issuing stock and using the proceeds to bridge the gap -- just this year the firm's shareholders approved an additional issue of 1 billion shares -- it goes without saying that this business model isn't infinitely sustainable either. Just ask Bernie Madoff or Allen Stanford.

3. Frontier Communications (Nasdaq: FTR  )
The last stock to make the list is Frontier Communications, a Connecticut-based telecommunications company. Founded in 1927, Frontier only recently became widely known after it purchased a large swath of Verizon's rural customer base in 2010, giving Frontier access to 4.8 million local access accounts, 2.2 million long-distance customers, and 1 million high-speed Internet customers.

While this transaction tripled Frontier's size, transforming the then-regional telecom into a national one overnight, it also nearly doubled the company's debt and increased its outstanding share count by a factor of 2.5. Then came additional consequences. At the beginning of this year, for instance, S&P downgraded Frontier's already junk-rated debt, and soon thereafter Frontier cut its dividend in half.

For a long time, the main concern was Frontier's dividend payout ratio -- the proportion of earnings or cash flow paid out as a dividend. In the second quarter of last year, for instance, the company paid out six times more in dividends than it recorded as net income and nearly 1.5 times its free cash flow. But as you can see below, this problem is now largely under control and indeed better than Frontier's competitor Windstream (Nasdaq: WIN  ) , which has paid out a full 99% of its free cash flow in the first six months of 2012.

Payout Ratios

Q2 2012

Q1 2012

Q4 2011

Q3 2011

Q2 2011

Net Income 5.79 3.84 4.51 9.58 5.96
EBITDA 0.31 0.26 0.49 0.50 0.48
Free Cash Flow 0.51 0.63 1.07 1.31 1.48

Source: Robotdough.com.

The bigger concern now is whether Frontier will be able to profitably consolidate its hold over the newly acquired domain. In a recent in-depth report on the company, our senior analyst Dan Caplinger equates Frontier's challenge with that of FairPoint communications, which bought customer territories from Verizon in 2008 only to then collapse under the added weight one year later. And to make matters worse, this is only one of four major threats identified in the report!

High dividend yields: The bottom line
Look, nobody's going to blame or judge you for investing in one of the megayielders listed above. As I said at the beginning, I'm consumed by greed when I see dividend yields in these ranges. But if you do choose to invest in one of the three companies discussed above, it's important that you do so with full knowledge of the risk.

Quite simply, these three companies aren't rock-solid dividend stocks. For aggressive investors, they combine the benefits of a dividend stock with the risks of a highly speculative growth stock.

If you're comfortable taking on that kind of risk, then I suggest you read Dan's in-depth report on Frontier located here. But if you're like most dividend investors and aren't comfortable making speculative investments, then the rock-solid dividend stocks identified in our popular free report will be more to your liking.

Fool contributor John Maxfield does not own shares in any of the companies mentioned above. The Motley Fool owns shares of Annaly Capital. Motley Fool newsletter services have recommended buying shares of Annaly Capital. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


Read/Post Comments (18) | Recommend This Article (23)

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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 August 13, 2012, at 12:42 PM, jonkai wrote:

    -------------

    As my colleague Rich Smith noted, "Not everyone is convinced that Annaly's beat was all that met the eye."

    -------------------

    in reality the shares went up when NLY reported... someone misled you..... they later went down after AGNC's report of a loss for their quarter....

    but what is horribly egregiously wrong about your statements is the one where you say NLY issues secondary shares to supply as dividends...

    i suggest you learn how an MReit works, and how NLY has had dividends of 13% or more for 15 years... including returning nearly 1000% to the shareholders..... if you reinvested those dividends....

    everything you indicated was in error except the 55 cent dividend... you probably need to do some more research on NLY for more than 1 hour....

    statement that 10 cents came from one time gains is just really "challenged"... (the 10 cents is wrong) and the whole underlying theory is wrong.... NLY routinely sales a very small part of it's portfolio in relation to the size of it's holdings every quarter for going on 15 years... so they are not one time gains.

    and he apparently assumed with the 10 cent gain that none of the expenses should be part of that gain... only part of the other gain.... geesh....

  • Report this Comment On August 13, 2012, at 1:17 PM, JohnMaxfield37 wrote:

    jonkai -

    Let me take your comment piece by piece...

    First, NLY reported earnings on Aug 1. It opened that day at $17.40 and closed at $17.31. And it also declined the following day, opening at $17.28 and closing at $17.22. In other words, nobody misled me, the shares did "slide a few cents" as I stated.

    Second, NLY has a track record of two things: (1) paying out more than its net income in dividends and (2) flooding the market with new share issues. Since 2007, its outstanding share count has gone from approximately 300 million shares to just under 1 billion. Meanwhile, its payout ratio has exceeded 100% for most of the same time period. We can all make our own deductions from that...

    Finally, while you're correct that NLY routinely sells a very small part of its portfolio in relation to the size of its holdings, an mREIT is not and as far as I know cannot be principally a trading house, as they'd lose their much coveted preferential tax treatment. Trading operations are accordingly incident to an mREIT's normal operations. And as a result, they can be conveniently juiced prior to earnings season. Now I'm not saying that's what NLY did here . . . but it certainly worked out nicely in their favor.

    John

  • Report this Comment On August 13, 2012, at 2:34 PM, jonkai wrote:

    First, NLY reported earnings on Aug 1.

    -----------------------------------------------------

    NLY reported earnings AFTER MARKET CLOSED on aug 1.... so you are not even starting from the correct date...

    on aug 2 shares opened at $17.28.... this is when trading started... in otherwords the first time volume could act on the stock after earnings..... the shares traded up to $17.35 before settling to $17.22 close.. or basically flat....

    AGNC reported that evening... with a loss in real earnings... which took both stocks down.....

    even then NLY traded even higher to $17.36 before starting a decline because of AGNC earnings.....

    why was the decline delayed? because AGNC had a false number as it's lead media number... AGNC in reality had a loss... and the market figured it out by the next day...

    these are not the actions of a market reacting negatively to a NLY's earnings.... they were exactly what the real market expected.... because they were real earnings, and Dividends are announced before earnings... so the earnings are predicted by the dividends in most cases for NLY....

    this was the reaction to a Market competitor engaged in the same business, and that competitor had bad earnings...

  • Report this Comment On August 13, 2012, at 2:37 PM, jonkai wrote:

    ---------

    Second, NLY has a track record of two things: (1) paying out more than its net income in dividends

    --------------

    uhh, don't you think NLY would have gone out of business by now.. 15 years later it is still paying out dividends, with a stock price higher than it was 15 years ago....

    why? because you are looking at the wrong earnings... which every drive by analyst does... MReits are REAL ESTATE, they have NON-CASH CHARGES.... get it.... they had unrealized losses... that eventually turn into realized losses or realized gains....

    now go back and figure out the earnings when you take out the NON-CASH "CHARGES to earnings"....

    see any differences there?????

  • Report this Comment On August 13, 2012, at 2:39 PM, sailrmac wrote:

    John,

    Jonkai is correct in that you are misunderstanding the operations of a mREIT. They issue new shares to raise capital which then then leverage and use to buy more mortgage assets. The cash flow (not the same as earnings) from these mortgage assets is utilized to pay the dividend.

    I'm not arguing that NLY is a good investment. There are better mREIT's out there and all mREIT's will likely get killed when short term rates eventually rise. I am arguing that you have mis-characterized the nature of NLY's stock issuances.

  • Report this Comment On August 13, 2012, at 2:47 PM, jonkai wrote:

    -------------------

    (2) flooding the market with new share issues. Since 2007

    ------------------

    they've been flooding the market for 15 years, not 6 years...

    why? because they buy things with the cash they receive.... did you even think to look at where the cash went? take a look at their assets over the years.....

    notice anything???? guess where every Secondary share went to?

    and every single one of those assets have produced more earnings.... look at the "interest income"... minus the "interest expense" lines on the income statement to see exactly why they buy these assets... and leverage them up....

    and why did they go into a frenzy in 2007? because they saw what was coming and made more money in the next 4 years than they ever did before.... while the rest of the market burned.....

    again.... it is probably not a good idea to 'analysis" a stock you don't own... mainly because you know nothing about a stock you don't own....

    where you learn a lot about a stock you do own....

    how can i tell you don't own NLY? because no one that did would have erred on every aspect of the stock...

    I have owned the stock for 10 years..... I know it like the back of my hand.... which is exactly like every other investor should know their stocks...

    do yourself a favor and buy 20 shares....(and reinvest the dividends) report back in a year.....

    then you will "know" the stock.

  • Report this Comment On August 13, 2012, at 3:06 PM, JohnMaxfield37 wrote:

    jonkai -

    You're clearly passionate about NLY and I appreciate that. And I also appreciate that it's given you great returns over the 10 years you've owned it. But I nevertheless disagree with the way you characterize NLY and its financial performance.

    You are correct, they did report after the market closed on Aug. 1. That's the reason I included the opening and closing figures for Aug. 2 -- a day in which NLY's shares also closed down by six cents.

    Second, while it's true that NLY's GAAP earnings will differ from its non-GAAP "Economic Net Income", those numbers should converge over time, as you intimated, and they haven't. The share issues or debt are the only other places that could have filled the dividend deficit over this extended time period. We can call this whatever we want, a dividend recapitalization or something more egregious, but that doesn't alter reality.

    Misallocating capital can go on for a long time before it catches up with a company. I believe that's what's going on at NLY. No doubt it'll be years before the rubber meets the road here, but I do believe it eventually will.

    John

  • Report this Comment On August 13, 2012, at 3:25 PM, JohnMaxfield37 wrote:

    sailrmac -

    Your explanation of how mREITs operate and my explanation in the article are nearly identical. So I don't think that's the issue you have.

    I don't want to put words in your mouth, but it seems like you disagree with my opinion that NLY uses some of its capital raised from the issue of stock to make up the deficit from the dividends.

    Because I addressed this above, however, let me take it one step further.

    The real reason NLY issues more shares is because its executives bonus on book value -- a dubious metric to bonus on to be sure. And in the absence of retained earnings, there's no other way to increase this metric other than to issue equity.

    Now, I understand that NLY's executives, particularly its CEO, drape themselves in the flag of homeownership, but that simply isn't why they issue new shares and leverage the proceeds. And lest you wonder why I'd question NLY's credibility in this regard, I encourage you to run a free broker check on its founder and CEO on FINRA's website. As you'll see, this isn't the first time he's mismanaged capital.

    John

  • Report this Comment On August 13, 2012, at 4:13 PM, hbofbyu wrote:

    " ...it goes without saying that this business model isn't infinitely sustainable either. Just ask Bernie Madoff or Allen Stanford..."

    - - - - - - - - - - - - - - - - - -

    It seems NLY has been doing the same thing since 1998. It may be likely that the dividend will drop a little in the next 3 years or so but is it really fair to compare it to a Bernie Madoff ponzi scheme?

    The Motley Fool owns shares of NLY. What has changed in NLY's operations and practices that now is fraudulent?

  • Report this Comment On August 13, 2012, at 4:24 PM, JohnMaxfield37 wrote:

    hbofbyu -

    Using newly raised capital to fund previously paid dividends isn't necessarily fraudulent in this context -- there's even a name for the practice: dividend recapitalization.

    Is this unethical? Perhaps. Unwise? I think so. But illegal? No -- though when you look at how private equity firms use dividend recaps it probably should be.

    Ethics, prudence, and legality aside, however, allocating capital in this way isn't infinitely sustainable. And that's why I cited Madoff and Stanford.

    John

  • Report this Comment On August 13, 2012, at 9:31 PM, emptorski wrote:

    When the author likened this to a Bernie-Madoff-style ponzi scheme, I had to jump in.

    If NLY issued new shares just to pay dividends with the proceeds, that would be ponzi, and unsustainable.

    But here is what NLY and similar mREITs do:

    Use the proceeds, leveraged some six times over, to buy mortgages backed by some government agency, such as Fannie or Freddie. The mortgage payments generate revenue.

    In short, the proceeds from stock issues generates revenue for them. Ergo, they are not a ponzi scheme.

    To maintain their REIT status, they are obligated to pay out 90% of their net income - not EPS, but net income - as dividends. Ergo, REITs generally have higher yields.

    Every investment has its own set of risks, and mREITs entail risks, as do all investments.

    NLY: Risky, sure. Ponzi, absolutely not.

  • Report this Comment On August 13, 2012, at 9:57 PM, JohnMaxfield37 wrote:

    emptorski -

    I don't mean to be critical, but you've slightly misinterpreted the article.

    It's true that NLY is a legitimate business concern. However, over an extended period, its dividend payments have exceeded its earnings. That NLY and its ilk use a non-GAAP figure to account for this should be viewed skeptically by investors. That aside, the must be made up somewhere. And given the amount of capital they raise by issuing new shares, it seems logical that's where they're making it up. Whether they pay out all of it, or only some of it, is simply a matter of degree. Either way, it's not infinitely sustainable.

    As a finally note, I must admit that I'm envious of your obvious faith in the veracity of corporate disclosures given the voluminous history of financial malfeasance.

    - John

  • Report this Comment On August 14, 2012, at 10:26 AM, jonkai wrote:

    ---------

    However, over an extended period, its dividend payments have exceeded its earnings

    --------------

    i am not clearly passionate about NLY, i am clearly an owner, and well researched on NLY....

    it is extremely clear that judging from your statements that you do not want to learn how MReits work...

    again, NLY's dividends do not exceed their real earnings... you are using the wrong earnings... those earnings include non cash charges... it is more than "challenged" to use non-cash earnings in trying to figure out an Mreit... period....

    what you described would be a ponzi scheme, where they raise cash from new investors to pay dividends to old investors... that is the definition of a ponzi scheme, NLY does not raise cash to payout dividends, they raise it to invest even more money in a market that is making massive profits... the more the profits, the more they invest.

    you've had like four people tell you you have this all wrong, and no one supporting your opinion... this is when you should start researching your opinion...

  • Report this Comment On August 14, 2012, at 11:49 AM, JohnMaxfield37 wrote:

    jonkai -

    With all due respect, the valued opinions of a vocal minority don't change my interpretation of NLY's performance.

    Like I said before, I think it's great that NLY has performed so well for you in the past and I hope you're right and that it continues to do so for the remainder of the time you hold it.

    John

  • Report this Comment On August 14, 2012, at 1:08 PM, jonkai wrote:

    yes, the last seeking alpha blogger had similar thoughts, he expressed it like so: "he makes a living at this" as he shorted NLY at $16.69... and he was going to hold till $14...

    I told him: "dying's a he(( of a way to make a living.."

    http://seekingalpha.com/article/448271-annaly-capital-the-be...

    his was an insane thing to do... he did the same thing you did... he looked at the wrong earnings.. nobody does that who have put more than a passing research glance at these stocks... regulation GAAP SEC "earnings' have nothing to do with actual cash flow.... ask yourself which "earnings" the IRS uses when they ask for their cut... then you get a quick understanding of which earnings count.

    that blogger later admitted he had to cover at a loss... (of course he fudged the losses by not including the dividends he had to pay)

    NLY hasn't just performed so well for me... every single investor who has invested in NLY long enough to get at least 1 dividend has made a profit.... every one who has held till today, and that trend is one that can only be changed by government policy. nothing less, nothing more. watch the government's fingers on anything reit related and one is also guaranteed to make a profit going forward indefinitely.... if you read the government correctly... not on interest rates, but on policy.

    the ONLY difference between the shareholder's profits between one another, is how many dividends they've held for...

    and those dividends have been coming from actual real profits including realized gains and losses...

    even using your GAAP "earnings" (which one would have to be foolish to use for a real estate trust),

    they showed .95 cents the first quarter and this quarter 55 cents... how exactly is that not covering the dividends this year?

  • Report this Comment On August 14, 2012, at 1:18 PM, JohnMaxfield37 wrote:

    The proof will ultimately be in the pudding.

  • Report this Comment On August 17, 2012, at 12:48 PM, WmHilger1 wrote:

    FairPoint and Frontier are birds of a feather. They are (were) both stuck by Verizon with a bunch of land-line customers who will (have already) slowly diminshed until they become too costly to service. BTW, I also put CenturyLink and Windstream in that same catgory. All of them are (were) too small and/or serve too small a market to long survive.

  • Report this Comment On August 17, 2012, at 5:49 PM, 1caflash wrote:

    John, you got the troops moving! I prefer smaller companies than the aforementioned, especially BDCs. My portfolio includes three monthly-payers: GAINP, MAIN, and PSEC. I like Hickory Tech. The only REIT for me is RSO-A, since I am an older, more conservative investor than some of you. Each of the common stocks is being dividend reinvested; the preferreds provide a cash stream. I enjoyed reading the article and the lively responses.

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