An Amazing Dividend Play

Dividend payers are supposed to be stodgy companies giving regular payouts to shareholders. There's an unspoken contract between shareholders and the companies they own: Shareholders are willing to sacrifice high-flying price appreciation so long as the company's dividend is steady and safe.

But what happens when the market has punished a dividend payer unfairly?

Then we have the rarest of rare occurrences: a stock with a huge, safe dividend as well as a better-than-average opportunity for price appreciation.

Today, I'm going to introduce you to a stock that sits in this uncommon territory.

But first, let's take a look at what's out there
I'll get back to that stock, and why it's so tempting, in just a minute. First, I'd like you to take a look at the six dividend stocks listed below and see whether you can spot the dividend dynamo I'm so excited about.

Company

Yield

Chimera Investment (NYSE: CIM  ) 17.4%
Annaly Capital (NYSE: NLY  ) 14.8%
Alaska Communications (Nasdaq: ALSK  ) 12.0%
Capstead Mortgage (NYSE: CMO  ) 14.9%
Aflac (NYSE: AFL  ) 3.4%
Hasbro (NYSE: HAS  ) 3.3%

Source: Yahoo! Finance.

Let's work backward to find our diamond in the rough.

First, let's boot these REITs
"REIT" is short for a real estate investment trust. These companies own income-producing assets. In exchange for not paying corporate income taxes, they must pay out at least 90% of their taxable income to shareholders, which accounts for their sky-high yields.

As fellow Fool Jeremy Phillips has pointed out, the business model for mortgage REITs like Annaly, Chimera, and Capstead is pretty simple: Borrow low-interest short-term loans and use it to purchase long-term mortgage-backed securities. Because current borrowing costs are basically zero, this is a pretty sweet deal.

But once the Federal Reserve starts inching rates upward -- and that day will come, whether two years or five years from now -- this juicy proposition will be no more. The stocks could easily crater when that day comes, eliminating all the gains you'll get from their dividends.

This eliminates Annaly, Chimera, and Capstead from my list.

Are these dividends built to last?
Communications companies have some of the highest yields out there; Alaska Communications is a perfect example of this. But here's the problem with the dividend that Alaska offers: There's no telling how long it'll be around.

Because telecoms have such high depreciation costs, the only way to really understand if they have enough cash to cover their dividends is to look at their free cash flow -- not their earnings.

Below is the payout ratio in 2010 for dividends paid from free cash flow.

Company

FCF Payout Ratio

Alaska Communications 84.4%

Source: Yahoo! Finance.

At first blush, this might appear to show that Alaska's dividend is safe. Fool dividend guru James Early states that he looks for companies with payout ratios below 80%, and Alaska comes in close to this bar.

But if we look a little closer, we see that an enormous deferred tax benefit helped free cash flow quite a bit. Take that benefit out, and the cash flow payout ratio jumps to 349%. While this isn't a make-or-break indictment of Alaska, I'm looking for the best dividend stock to invest in now.

And then there were two...
This leaves us with just two companies left to evaluate. Below, I've listed some valuation metrics that help clear up the picture.

Company

% Below 52-Week High

P/E

PEG Ratio

Aflac 37.6% 9.8 0.81
Hasbro 24.9% 14.3 0.92

Source: Yahoo! Finance.

Aflac and Hasbro, with their low PEG ratios and significant drops within the last year, definitely qualify as potential bargains.

So which one is it?
Much as I love Mr. Potato Head, I have to give Hasbro the old heave-ho as well. As I've written in the past, I just don't have faith in its growth plans. The young sages that I consult (my preteen cousins) have no interest in watching The Hub, and I'm not holding out hope for Hasbro's latest slate of movies to improve toy sales either.

That leaves Aflac as the lone stock left. Everyone's favorite duck has raised its dividend for 28 consecutive years, growing at more than 20% per year for the last five years, and only uses 26% of its earnings to pay its shareholders. These are robust numbers!

So what's the catch?
The past few months have not been kind to Aflac. The reason for their recent fall has less to do with the actual company than it does with what's happening in Europe.

As an insurance company, Aflac takes the premiums that policy holders pay and invests it. Though usually conservative in placing their bets, Aflac has heavy exposure to European sovereign debt. Investors are worried that should any nation default on its debt, Aflac could be left empty-handed.

This situation isn't without precedent. Back in 2009, a similar scare occurred, knocking Aflac's stock all the way down to the absurdly low price of $10.83. One year later, the stock sat at $51.53, a 375% increase.

Is that situation guaranteed to repeat itself? There are no guarantees.

But just as U.S. politicians were able to buckle down and raise the debt ceiling at the last minute, I just can't see the wealthier EU nations (read: Germany and France) allowing their currency to implode by not bailing out countries like Portugal, Italy, Ireland, Greece, and Spain (the PIIGS).

Want another stock idea that is usually associated with capital preservation, but has recently shown great potential for capital appreciation as well? Then I invite you to take a look at our latest special free report: "The Tiny Gold Stock Digging Up Massive Profits." Inside, you'll read about a little-known company making a fortune in Canada. It's yours today, absolutely free!

Fool contributor Brian Stoffel was lucky enough to buy Aflac in February of 2009. He still owns shares of Aflac. The Motley Fool owns shares of Annaly Capital Management, Aflac, and Chimera Investment. Motley Fool newsletter services have recommended buying shares of Aflac and Hasbro. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (2) | Recommend This Article (19)

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 August 30, 2011, at 12:25 PM, williamg2 wrote:

    Apparantly other Fool analysts do not agree with your accessment of Hasbro. HAS is a Stock Advisor recommendation and a Income Investor recommendation. My daughter loves watching HUB by the way and I have spent enough money buying her the "My Little Pony" toys to buy several shares of Hasbro!

  • Report this Comment On August 30, 2011, at 5:11 PM, TMFCheesehead wrote:

    williamg2-

    You are absolutely right, the teams at SA and II would disagree with me on this one, but that's the beauty of investing: everyone does their own due diligence and reaches their own conclusion.

    Brian Stoffel

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Related Tickers

10/24/2014 4:02 PM
AFL $58.54 Up +0.46 +0.79%
Aflac CAPS Rating: *****
ALSK $1.39 Up +0.02 +1.46%
Alaska Communicati… CAPS Rating: **
CIM $3.09 Up +0.02 +0.65%
Chimera Investment CAPS Rating: ***
CMO $12.80 Down -0.02 -0.16%
Capstead Mortgage… CAPS Rating: ****
NLY $11.36 Up +0.07 +0.62%
Annaly Capital Man… CAPS Rating: ****

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