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What if I told you I've found you a dividend-paying stock with a seriously eye-catching 10.5% yield? What if I said that the same stock was trading at less than 14 times trailing earnings and is in the hot metals sector? Sound interesting?
Sure it does. That is, until you find out that the company will cease to exist in a little over four years, and there's almost no chance that the dividends between now and then will justify the stock's current price.
The big dividend you don't want
The stock that I'm talking about is Great Northern Iron Ore Properties (NYSE: GNI ) , a property trust that owns iron-producing properties in Minnesota.
A family member recently sent me a research report on the stock and asked for my opinion on it. After perusing the report, I did what I always do when researching a stock -- I pulled up its most recent annual report. There, I was immediately met with a very simple, very important fact that the research report had completely overlooked: The fact that on April 6, 2015, the properties of the company will be transferred to ConocoPhillips (NYSE: COP ) , the company will be dissolved, and the stock shares retired.
How a research report could possibly overlook a fact like that boggles my mind, but the bottom line is that investors only have a few years to recoup their investment before the company disappears.
Over the past few years, distributions from Great Northern have bounced around a bit, but have averaged $2.62 per quarter, and peaked at $4.50 in the fourth quarter of 2008. The fourth quarter 2010 distribution was $3.75.
There are 17 quarters remaining that Great Northern will pay a regular distribution, and at the time of dissolution, it will also pay out a final distribution. Even if we assume that every distribution over those 17 quarters is at the peak level of $4.50, that sum, along with the company's current rough estimate of the final distribution ($8.53 per share), comes out to $85 -- way below the current share price of $136. And that rough calculation doesn't even discount the future distributions (a $4.50 distribution in 2014 isn't worth $4.50 today).
So why are investors paying so much? Perhaps they are extremely bullish on iron ore prices and think that future distributions will be much higher than historical distributions. Or investors may simply not be doing proper diligence on their investments and fell in love with Great Northern's yield without ever realizing that the company is counting down the days until it disappears.
Getting to know your dividends
As dividends have increasingly come back into vogue, investors have been taken with stocks that are pumping out huge payouts. Many of the names at the very top of the yield list all come from one small neighborhood -- the mortgage-backed security REITs. That list includes Annaly Capital (NYSE: NLY ) with a 14.3% yield, Chimera Investment (NYSE: CIM ) with a 16.5% yield, and American Capital Agency (Nasdaq: AGNC ) with a whopping 19.5% payout.
For obvious reasons, those double-digit yields have pulled in investors like a space-age tractor beam. But investors had better understand the businesses behind these companies if they plan to invest.
The Cliff's Notes version is that they finance themselves through short-term borrowings, purchase mortgage notes, and then pocket the spread. That spread is nice and juicy when rates are ridiculously low -- as they are now -- but compress when rates start to rise. Not only can this mean smaller dividends for shareholders, but it may also mean capital losses as stock prices drop in response to falling payouts.
Annaly, which has more of a history than the others, provides an illustration on how this could play out when rates start to rise again. When the economy got into trouble after the Internet bubble popped, the Federal Reserve cut rates, which helped Annaly's bottom line spike. But once the economy found its sea legs again and rates were pushed back up, Annaly's dividend and stock price fell. Between 2002 and 2006 the dividend payout dropped from $2.67 to $0.57 while the stock price retreated from a high of more than $21 in mid-2002 to less than $11 at the end of 2005.
Will history repeat itself during this cycle? That remains to be seen, but investors better understand what risks they're facing as they chase those huge yields.
My kind of dividends
Since the core of my personal portfolio is made up of dividend payers, I look for companies that I can count on to deliver year-in and year-out. Sure, no business is a 100% certainty, but there are plenty that I believe will provide attractive returns and still allow me to sleep soundly.
AT&T (NYSE: T ) , for example, may not be on anyone's list of scorching growth stocks, but it has a solid, dependable business that consistently produces more than enough cash to pay its dividend. The stock currently yields almost 6%, and I think it's undervalued to boot.
Wal-Mart (NYSE: WMT ) is another favorite of mine. In this case, you're not getting nearly the yield of AT&T -- the current payout is only 2.2%. However, with this pick, you not only once again get a solid, dependable business, but one that has much more opportunity for growth. And speaking of growth, Wal-Mart has nearly doubled its dividend since 2006, and its payout ratio of just 29% gives it plenty of room to boost the payout further.
Do you have to forgo mouth-watering double-digit yields in favor of a punier payout? Of course not. But while truly wacky situations like Great Northern are few and far between, it's a great warning as to why investors absolutely must look beyond the dividend yield and figure out what's going on under the hood.