Too good to be true.
That’s the phrase that pops into my mind a few times a day, every day, when it comes to the stock market. Whether it’s a shockingly low P/E ratio, the next can’t-miss growth stock, or a merger rife with “synergies,” I try to question everything.
The same goes for sky-high dividend yields. As a general rule, I love dividends. They simultaneously make a company’s management more efficient with their funds and return money to you, the shareholder. But at a certain point, you have to wonder if big dividends are too good to be true.
That’s because when dividend stocks fail you, they can really fail you. When trouble strikes, it’s not unusual to see a company’s stock price plummet along with its dividend payouts.
So with every big dividend out there, we have to ask: Is it sustainable? To help you identify some stocks that balance high dividend yields and high sustainability, I went down the list of every non-micro-cap stock with a dividend yield above 5% (there are 296 stocks) in search of high-yield dividends that also have high trust factors. Here are my summarized thoughts and stock ideas.
The biggest of the big
Dominating the top of the high-yielders list are mortgage REITs. There are quite a few sporting dividend yields above 10%. In fact, Invesco Mortgage (NYSE: IVR ) and American Capital Agency (Nasdaq: AGNC ) lead the entire market with yields of 22.3% and 20.3%.
If these numbers sound too good to be true, they just may be. When you look at the business models employed here, there is a striking resemblance to the trading desks of Wall Street firms. Both benefit from the yield curve by borrowing cheaply with short-term interest rates and lending at more expensive long-term rates. Both juice their returns through high leverage. And both have difficult-to-navigate balance sheets that contain risks management tries to hedge away.
Problems happen when the ability to borrow dries up or when the interest spread contracts. We saw what could happen in 2008 when Wall Street banks Bear Stearns and Lehman Brothers effectively went under.
That said, at their current dividend rates, it would take less than five years of success for Invesco and American Capital Agency to pay back your investment. At that point, anything extra is pure return (assuming no taxes and no dividend reinvestment). But if I had to buy a mortgage REIT, it wouldn’t be either of these two. Why? To begin with, they were born the same year Bear Stearns and Lehman went under. A three-year track record isn’t a long enough period to judge management.
Instead, if you’re looking to explore mortgage REITs, I’d start with Annaly Capital (NYSE: NLY ) and Chimera (NYSE: CIM ) (whose portfolio is managed by Annaly). Annaly itself has only been around since 1996, but 15 years is a heck of a lot longer than three. It’s smashed the market over that period and has dealt with rising interest rates before. And I like what I’ve seen from Annaly CEO Michael Farrell.
Trust factor: Many investors (including me) struggle with this sector. There are a lot of “ifs.” If the Fed keeps short-term interest rates low for an extended period, if the regulatory environment stays favorable to mortgage REITs, and if the individual company you select manages its portfolio wisely, there could be market-thrashing outperformance here. Is there opportunity here? Maybe. But are these high-trust dividend yields? No.
The telecom sector, though not regulatorily compelled to pay dividends like REITs are, is rife with big dividend payers on the carrier front. This is true both domestically and internationally. Looking at the list of big yielders, the following companies jump out because of their recent declines. Remember that when a company’s stock price goes down, its dividend yield goes up.
Drop From 2-year High
Likely Reason for Drop
|Alaska Communications (Nasdaq: ALSK )
||High debt, losses.
|Frontier Communications (NYSE: FTR )
||High debt, big acquisition, hidden profits.
|Portugal Telecom (NYSE: PT )
|Telefonica (NYSE: TEF )
|France Telecom (NYSE: FTE )
Source: S&P Capital IQ and Yahoo! Finance.
On the domestic side, we see that high debt loads and operational worries have led to decreased stock prices and resulting super-high yields for Alaska and Frontier. It’s instructive to note that fellow rural telecom Windstream is only off 17% from its two-year highs.
We should also note that although Alaska has negative earnings and Frontier’s P/E ratio looks quite high for an ultimately dying business, each of their free cash flows far outstrip their earnings. However, only Frontier's free cash flows have been big enough to cover its dividends. Frontier tripled its size via an asset deal with Verizon, so any trust there is based on your assessment of Frontier’s operational prowess.
On the foreign telecom side, having operations headquartered in Portugal, Spain, and France doesn’t bode well for stock prices during a European sovereign debt crisis. But each telecom can boast substantial amounts of business outside of Europe, and each is an interesting play if you believe that the effect of a banking crisis has been factored too heavily into these providers of basic communication needs.
Trust factor: All the telecoms in the table above, except Alaska, seem worth a serious second look. But like the mortgage REITs, although I see possible opportunity (so far, I’ve bought Frontier myself), none are quite sleep-soundly-at-night stocks.
The highest-yielding stocks you can trust
I believe two other high-yielders are more trustworthy than any we’ve discussed so far.
The first is a controversial, unlikely one. Believe it or not, it’s tobacco giant Altria (NYSE: MO ) and its 6% dividend yield. We all know it has serious litigation risk, and I’ll also add that its balance sheet is quite leveraged. But the litigation risk is there for all to see; it’s a risk that has plagued Altria for decades as its strong dividends have helped it beat the market. As for its use of a lot of debt, Altria can only do so because its business is so predictable. Tobacco usage is going to continue to decline in this country, but Altria has the pricing power to offset those declines with price increases. The leverage is a calculated move that allows Altria to return these high dividends to shareholders.
Right now, its stock is priced moderately, but not ultra-cheaply. Let’s move on to a cheaper alternative -- a quirky dividend stock hidden in Wisconsin.
National Presto (NYSE: NPK ) is one-half defense contractor, 1/3 kitchen appliance purveyor, and 1/6 adult diaper manufacturer. I told you it was quirky. As I’ve detailed before, what makes it especially compelling is its policy of issuing a small annual dividend supplemented by a massive annual special dividend. The result is an 8.7% dividend yield masquerading as a 1.1% dividend yield on Yahoo! Finance.
The main risks in this company are its reliance on a handful of customers and its operations in the defense industry (a risk because of the unknowableness of budget talks). However, National Presto’s lack of debt, its cash position equaling a sixth of its market cap, and its sub-10 P/E ratio have me trusting this one as much as you can trust a unique small-cap conglomerate that can pull its special dividend at any time.
I never said high-yield dividend investing was easy. And it isn’t. The increased dividend yields usually come at the price of a leveraged balance sheet, a dying business model, or a stock that’s been understandably beaten down by the market. If you’d like to explore safer alternatives, we’ve detailed 13 ideas in our free dividend report, including a mini-report called “5 Dividend Stocks for the Next 50 Years.” To read your free copy now, while it’s still available, just click here.