Should You Chase the Biggest, Fattest Dividends?

I'm a very firm believer in the good old maxim: "If it seems too good to be true, it probably is."

There are few corners of the market that get me repeating that phrase (like a drunken lunatic) more than high-yield stocks. Let's be perfectly clear about what I mean when I say "high yield." With 10-year Treasuries yielding less than 2.7% and many large blue chips kicking out 3% to 4%, there are a lot of stocks with attractive yields. But when I say "high yield" I'm talking about stocks like Annaly Capital (NYSE: NLY  ) , which is paying 15.2%, and Cellcom Israel, which is kicking out 11.3%. Now those are high yields.

High is good?
But are they too good to be true? Or too good to pass up? That was the query I wanted some sort of concrete(ish) answer to. So I decided to look to history for some help.

I started by heading back to the beginning of 2000 where, despite the massively overvalued market, there were still quite a number of stocks with hefty yields. What I did was grab the largest 500 companies that paid dividends at the time, then narrowed the list to the 25 with the largest yields. I then took a look at what happened to each company's dividend and how the stock performed.

What I found was a bit of good news and a bit of bad news. But first, here are the numbers.

 

Yield

1-Year Dividend Growth

Dividend Growth from 1999 to Last 12 Months

Dividend-Adjusted Stock Returns

25-Company Average

9.9%

(12.8%)

(25.4%)

211.5%

Sources: Capital IQ, a Standard & Poor's company; Yahoo! Finance; and author's calculations.

Looking above, the bad news is obvious: The dividends for these companies shrunk on average. In fact, over the next year, more than a third of the top 25 yielders cut their dividend by some amount. Over the past 12 months, a teeth-rattling 84% of these companies had a lower dividend than they did in 2000. In other words, the market pretty much had it right -- the respective dividends at the time weren't sustainable.

However -- and that's a "however" with a very capital "H" -- as a group these stocks absolutely trounced the S&P 500's performance. As you can see in the chart above, the group delivered nearly 212% in dividend-adjusted returns while the S&P lost nearly 24%. And it's not like a few standouts carried the group; 84% of the stocks in this group outperformed the S&P.

Asset manager AllianceBernstein was among this list. As part of its partnership agreement, the company distributes all of its cash flow to shareholders. This means big payouts, but not necessarily dependable ones. Back in 1999, the company paid out $2.49, and over the past year it only paid $2.06.

But over the course of the past decade-plus, the company has paid out so much that even a drop in the stock price couldn't keep the stock from claiming market-beating performance.

Not satisfied with just one time period, I did the exact same thing starting in 2005 and came up with very similar results.

 

Yield

1-Year Dividend Growth

Dividend Growth from 2004 to Last 12 Months

Dividend-Adjusted Stock Returns

25-Company Average

9.7%

3.5%

(15%)

76.4%

Sources: Capital IQ, a Standard & Poor's company; Yahoo! Finance; and author's calculations.

This time, dividends, on average, grew over the next year, but between 2004 and now a full 64% of those companies had cut down their payout. But once again the group trounced the S&P. On average, the top 25 yielders returned a dividend-adjusted 76.4%, and a full 80% of them beat the S&P's 7.5% loss.

Among the stocks helping this group slap around the market was BP Prudhoe Bay Royalty Trust (NYSE: BPT  ) . This Alaskan royalty trust performed better than most of the group, more than doubling its dividend between 2004 and the recent 12-month period. Its 279% dividend-adjusted return trounced the market, and its 8.6% current yield actually tops the 7.9% yield it showed in 2005.

Today's big payouts
So what stocks are kicking out huge dividends today? Here's a look at the top 10.

Company

Industry

Yield

American Capital Agency (Nasdaq: AGNC  )

Real estate

19.8%

PDL BioPharma (Nasdaq: PDLI  )

Biotechnology

18.9%

Cypress Sharpridge Investments

Real estate

17.0%

Chimera Investment Corporation (NYSE: CIM  )

Real estate

16.5%

Resource Capital (NYSE: RSO  )

Real estate

15.9%

Annaly Capital Management

Real estate

15.2%

Hatteras Financial

Real estate

14.9%

Anworth Mortgage Asset (NYSE: ANH  )

Real estate

14.5%

Invesco Mortgage Capital

Real estate

13.7%

MV Oil Trust

Oil & Gas

13.5%

Source: Capital IQ, a Standard & Poor's company.

Notice a theme here?

And even though you might expect to see some diversity under the heading "real estate," many of these companies are extremely similar. For example, American Capital Agency, Annaly Capital, and Anworth Mortgage all focus on buying agency mortgage-backed securities -- that is, mortgage securities backed by Fannie Mae, Freddie Mac, or Ginnie Mae. Chimera has a very similar strategy, except that it ventures outside the safety of agency-backed securities. Resource Capital mixes it up just a bit more by focusing on commercial mortgage and financing loans.

I've made it fairly clear that I'm not much of a fan of Annaly's business model, which basically rests on simply collecting the spread between borrowing costs and the agency-backed debt it buys. By extension, that means that I'm also not too keen on many of the names in the list above.

Of course, the historical data above does make me wonder if I should look past my business-model distaste and focus instead on the potential for big dividends delivering attractive results. But even if that's the case, it still wouldn't be advisable to stuff your portfolio full of these mortgage investors.

Fortunately, there are other high-yield opportunities as well. PDL BioPharma is an interesting little company that collects royalty income from a portfolio of biotech patents. MV Oil Trust is exactly what it sounds like -- a trust that owns oil-property profit interests. Scrolling past the list above, Tele Norte Leste Participacoes and Cellcom Israel -- both of which also have double-digit yields -- are telecom providers in Brazil and Israel, respectively.

But no matter which stocks you end up drilling down on, the bottom line is that even though they may look too good to be true, big dividend yields may deserve a home in your portfolio.

Have a particular favorite among the high yielders? Head down to the comments section and share your thoughts.

High yielders may not be as dangerous as I originally thought, but these companies could have trouble brewing.

Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or on his RSS feed. The Fool's disclosure policy assures you no Wookies were harmed in the making of this article.


Read/Post Comments (21) | Recommend This Article (48)

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 September 16, 2010, at 7:31 PM, TMFMMTInvestor wrote:

    Out of curiosity, Matt, if Annaly is so bad, why do you think the MF Independence Fund holds it as a top 10 position? It certainly provides a decent chunk of capital to redeploy into other businesses.

    Scott

  • Report this Comment On September 16, 2010, at 8:00 PM, jkeesing wrote:

    Thanks for the great historical analysis. One point worth mentioning is to make sure that the buyer of these higher dividend stocks reinvests the vast portion of the dividends to reap the compounded reward of substantial growth besides the cash flow!

  • Report this Comment On September 17, 2010, at 3:10 AM, EllenBrandtPhD wrote:

    I use "technical analysis of propaganda!"

    Even though CIM has a very small legal Short position, we have been treated to a couple of weeks now of truly excessive - and rather silly - Short-oriented postings all over the financial site universe.

    To me, that means CIM might raise its quarterly dividend this time out - they had a very nice earnings report - putting the Shorts, especially any naked ones - in a state of veritable panic.

    They know they might be liable for paying out dividends to the large institutions who tend to stay put in the stock right through the ex-dividend date. CIM still has a relatively small proportion of retail investors. It's largely an institutional stock.

    In any case, though one can't count on it, if CIM does raise, there is going to be a frenzy of buying by these panicky Shorts.

    Note that the stock's annual high is quite modest. It might conceivably be taken out or even overshot.

  • Report this Comment On September 17, 2010, at 8:11 AM, pondee619 wrote:

    sjf2005:

    You asked:

    "Out of curiosity, Matt, if Annaly is so bad, why do you think the MF Independence Fund holds it as a top 10 position?"

    Because, this site is not THE Motley Fool, it is THESE/THOSE Motley FoolS. A group of people with differing views and opinions. Read enough of their "stories' and you will find every opiniion available on every stock/issue. The Fool can't be wrong because all bases are covered. Its fool writers can be. Your job, devine which is which. Love a stock or hate a stock you will find a fool "article" to support your opinion. Frequently on the same day. Kinda funny how investing "Foolishly" can contradict itself so often.

  • Report this Comment On September 17, 2010, at 11:14 AM, Realexdivy wrote:

    I own RSO and consider it the best stock in my portfolio.

    I rate it higher than the other REITs on the list because of its opportunity for price appreciation. One reason it is an "accidental high-yielder" is a recent secondary offering. That dropped the share price, but the dividend held constant and Book Value held constant.

    RSO was trading at $7.55 just a few months ago, before the offering. As all of the flippers leave, the price should continue towards that number and beyond.

    AS if that wasn't enough, the CEO, in the last CC, said they intend to start "growing" the dividend (previously, they have been defensive).

    BTW, RSO never failed to pay a "meaningful" cash dividend - even during the crisis.

  • Report this Comment On September 17, 2010, at 4:24 PM, TMFKopp wrote:

    @sjf2005

    "Out of curiosity, Matt, if Annaly is so bad, why do you think the MF Independence Fund holds it as a top 10 position? It certainly provides a decent chunk of capital to redeploy into other businesses."

    Unfortunately, I can't speak for the Independence Fund -- they keep that unit very separate for legal reasons. So your best bet is to check out their commentary (http://www.foolfunds.com/commentary/2010/09/letter-to-shareh... and see if they mention it there.

    If I were to speculate, I'd guess that the fund probably holds a lot of it for similar reasons to other folks -- it pays an amazingly high dividend and it doesn't look like the Fed is going to start raising rates any time soon. Oh, and the fact that it has a successful track record (even if it is on the shorter side).

    Bill Mann -- who runs the Independence Fund -- is one of the sharper investors I've ever met (I worked with him before the launch of the Fool Funds), so it wouldn't surprise me if he's very right and I'm very wrong. And frankly, a lot of the facts are not in my favor on this one. In addition to the points I just noted, there's the whole issue of the subject of the article above -- that is, that high yielders tend to pummel the market.

    But I just can't get comfortable with the business model so it's unlikely I'll end up counting myself as an investor. As I noted in a previous article (http://www.fool.com/investing/general/2010/08/31/i-hate-this..., my conviction isn't strong enough to short, it's just strong enough to keep me on the sidelines altogether.

    Matt

  • Report this Comment On September 17, 2010, at 4:24 PM, TMFKopp wrote:

    @jkeesing

    "One point worth mentioning is to make sure that the buyer of these higher dividend stocks reinvests the vast portion of the dividends to reap the compounded reward of substantial growth besides the cash flow! "

    Great point!

    Matt

  • Report this Comment On September 17, 2010, at 4:31 PM, TMFKopp wrote:

    @Venerability

    "To me, that means CIM might raise its quarterly dividend this time out - they had a very nice earnings report - putting the Shorts, especially any naked ones - in a state of veritable panic."

    When it comes to the "REITs" above (quotes because their business models make them quasi-REITs in my mind), there may be room to raise the dividend in the short term. But one thing I'd probably count on for most, if not all, of them in the future is that the dividend will probably come down.

    Just as the historical numbers I dug into showed that high yielders tend to beat the market, it also seemed to say that in many cases a particularly high yield usually did signal future declines in the payout rate.

    This certainly is no guarantee, but if I decided to invest in any of them I'd count on that to be conservative.

    But the real questions (in my mind at least) are: Even if dividends are cut, how much will they be cut by? And, more importantly, will they still be able to outperform the rest of the market?

    The two time periods I examined above are hardly enough to prove a natural law, but the numbers seem to say that in general even though high yielders tend to cut payouts, they also tend to outperform.

    Matt

  • Report this Comment On September 17, 2010, at 4:34 PM, ContraryDude wrote:

    I have been "chasing" these fat dividends in my IRA. But rather than NLY, I decided to purchase shares of MFA, which has a similar business model and yield. I also like RSO and it has held up nicely so far.

    Others that fit the fat dividend category that I hold in my IRA include some BDCs. Currently those include AINV (11%) and PNNT (10%). A little higher risk perhaps, but that is what it takes for the big reward.

  • Report this Comment On September 17, 2010, at 4:41 PM, TMFKopp wrote:

    @pondee619

    "Because, this site is not THE Motley Fool, it is THESE/THOSE Motley FoolS. A group of people with differing views and opinions."

    This seems to really get your goat, eh? Would you prefer that we all parrot a single point of view on everything, even if we disagree with that view?

    Also, you may want to modify "THESE/THOSE" in your spiel. We tend to think of the Fool as much as a community of investors as anything else, so many of our readers would probably say "WE Motley Fools." (I was a member of the Fool community for years before I began writing for the website).

    I think most investors realize that investing is not a world of blacks and whites, it's a heck of a lot of shades of gray. Limiting discussion and disagreement to make it seem like investing is black and white would, in my view, be a huge disservice to our readers.

    If what you're looking for is tailored investment advice that says "Pondee, THIS is exactly what YOU should be investing in" then I would suggest consulting an investment adviser -- that's exactly what their job is.

    However, I've found that as an investor myself, when I'm trying to figure out what to invest in I want to hear all sides of the discussion -- the good, the bad, and the indifferent.

    Matt

  • Report this Comment On September 17, 2010, at 4:50 PM, TMFKopp wrote:

    @Realexdivy and ContraryDude

    I'll have to dig in more to RSO. What's interesting is that many observers were waiting for some huge apocalypse in commercial real estate. Now CRE hasn't been in great shape, but it hasn't exactly unraveled at the seams. Maybe that's still to come, but if not there could be a lot of people that will flock back to a stock like RSO.

    As for the BDCs, an interesting note in the collection of 50 stocks from the two periods, two of them were BDCs -- EQS and ACAS -- and both performed extremely poorly. Obviously that's a small observation group, but it jumped out at me.

    Matt

  • Report this Comment On September 18, 2010, at 2:36 PM, EllenBrandtPhD wrote:

    Matt,

    Remember, the yield goes down as the stock price goes up.

    CIM is much more modestly priced than many of its peers. Its current annual high is very modest.

    And the fact that the Short position is down markedly, even in the face of dilution, seems to point to a significantly higher price soon - if not this quarter, next.

  • Report this Comment On September 18, 2010, at 3:26 PM, sigma wrote:

    What about PDLI in biotech? How is it maintainig such high yields(19.9%)?

  • Report this Comment On September 19, 2010, at 6:39 PM, 1caflash wrote:

    Sept. 8, 2010, my Financial Advisor helped me Buy 4,500 CIM shares in my larger account, and 4,400 shares in my tax-deferred IRA, bringing the totals to 10,000 and 13,000 shares. We like ARCC [Ares Capital] also. CIM has NO REASON to Raise Its Dividend when It makes the announcement; Chimera raised it within the last year. You can't buy much with seventeen cents. Multiply .17 X 23,000.....well,now! Remember, Dividends + Growth are Very Sexy. PDLI might be OK, but I'd rather stay clear of investments that promise "Special Dividends", and I don't know much about Bio-Tech. I have no shares of RSO, NRO or NRF, but I like these three.

  • Report this Comment On September 20, 2010, at 4:24 AM, TMFKopp wrote:

    @Venerability

    "Remember, the yield goes down as the stock price goes up."

    Say more, I'm not quite sure what you're getting at.

    Matt

  • Report this Comment On September 20, 2010, at 4:27 AM, TMFKopp wrote:

    @chuckshipley

    "What about PDLI in biotech? How is it maintainig such high yields(19.9%)?"

    The simple answer is that it's not a biotech in the more traditional sense of the word. The company manages a portfolio of biotech patents that it collects royalties on. So it has very few bills to pay, good income, and likes getting that income back out to shareholders.

    The downside though, is that those patents and royalties are not going to last forever. And, actually, if things don't go the company's way, those royalties may not last very long at all...

    But that's the trade-off -- there's risk to the royalty stream, but for taking on that risk, investors have the potential of big returns from dividends and possibly also capital gains.

    Matt

  • Report this Comment On September 22, 2010, at 4:34 PM, 1caflash wrote:

    O.K., I Was Wrong. Chimera RAISED Its Dividend by One Cent; Over 5% for This Quarter, and the Second Time within a Year! I'm eating crow in a nice way.

  • Report this Comment On September 23, 2010, at 12:42 PM, EllenBrandtPhD wrote:

    Kudos to me, please!

    I was just about the only one who predicted it.

    Matt,

    What I meant was that as the stock price goes up - as it definitely will now - the yield automatically adjusts lower at the same dividend amount.

    CIM was very smart to raise at this time, IMO. It has an excellent chance of going over $5 on good earnings next time out. And this raise implies they will be good.

  • Report this Comment On September 24, 2010, at 10:21 PM, philkek wrote:

    Thanks MF and fellow fools. I find this an educational article with good leads in symbols and advice. I like high dividends. Thought provoking at the least. Better Business Bureau warns all fools to Investigate BEFORE you invest. This article starts my investigation. I hope to buy something soon after my homework on fundamentals. Fool on for profits.

  • Report this Comment On September 27, 2010, at 4:18 PM, richpoorman wrote:

    I see one possible problem with this analysis. Even one stock going bust in any group of 25 would bring the return down substatially. These are groups of stocks that have high risk of failure. Did you inadvertently omit any stock that failed from the historical selections so that you would be able to track dividends to the present? And thus not realize that this would both skew returns and make future returns of stocks selected from the same group not comparable? My kudos to your method of preselection if it was rigorous and not even one of the two groups of 25 stocks went belly up. If not, please fess up or explain.

  • Report this Comment On September 28, 2010, at 6:01 AM, elv1659 wrote:

    As long as interest rates stay low, these companies can borrow low and invest in mortgages that pay a higher interest rate. They make the difference in the rates!! Sounds sound to me, like banks do all the time. You get 1% or less on your deposits and the bank lends it out at much higher rates.

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