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.

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.

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.

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.