More often than not, dividend-paying stocks form the foundation of any successful long-term investment portfolio. They also, coincidentally, tend to handily outperform their non-dividend-paying peers over time.
But aside from sheer outperformance, dividend stocks bring three benefits to the table that investors seem to appreciate. First, dividend stocks usually have time-tested business models and relatively clear long-term outlooks -- otherwise they wouldn't be sharing a percentage of their profits with shareholders. Second, dividend payouts act as a means to partially hedge against the inevitable "hiccups" the stock market undergoes. Finally, dividends can be reinvested back into more shares of dividend-paying stock, supercharging your ability to build wealth.
The great dividend conundrum
However, dividends also offer investors quite the conundrum: We want the highest yield possible, but we also want the payout to be sustainable over a long period of time. Though each case varies, the higher the yield, the more unsustainable the payout. Remember, dividend yield is a function of the total payout and a stock's share price. As an example, if a company's underlying business model is in trouble, and its share price loses 50%, its dividend yield will double, providing a dangerous lure for unsuspecting investors.
This battle between our better judgment and our desire for the highest yield imaginable is often waged most fiercely among dividend stocks with double-digit yields. Right now, there are around 100 publicly traded stocks paying out in excess of 10% annually, albeit this figure may include one-time special dividends paid out over the past year.
Are these high-yielding dividends sustainable?
Three high-yielding stocks among this group of roughly 100 publicly traded companies caught my attention: Alliance Resource Partners (NASDAQ:ARLP), Annaly Capital Management (NYSE:NLY), and GameStop (NYSE:GME). The big question is: Are their 11% dividend yields for real?
Let's have a closer look.
Alliance Resource Partners: 11.9% yield
Before you run for the hills, let me come clean: Yes, Alliance Resource Partners is a coal producer. And yes, coal producers aren't exactly thriving at the moment. But make no mistake about it, Alliance Resource isn't anything like its peers.
The first difference to be found can be seen in the company's balance sheet. The company's latest quarterly results, reported on Monday, showed $28.8 million in cash and cash equivalents, and a subsequent $29.2 million reduction in long-term debt. Whereas most of its peers are lugging around $1 billion or more in long-term debt, Alliance Resource Partners has well below this amount, giving it the financial flexibility to make deals and adjust production as demand calls for. Many of its competitors simply don't have that luxury.
It's also done a remarkably good job of minimizing its exposure to wholesale coal prices by locking in production well in advance. According to CEO Joseph Craft III, "During the 2018 Quarter, ARLP reached agreement to deliver up to 19.7 million tons in 2018 through 2022, including an additional 4.8 million tons for delivery this year." This added booking in 2018 actually caused the company to up its full-year production guidance to a new range of 40 million to 41 million tons of coal, representing 8% year-on-year growth at the midpoint. More than 17 million tons are booked for 2019, with nearly 12 million committed for 2020.
Though coal has certainly faced no shortage of headwinds, it still accounts for around 30% of all electricity generation in the U.S., which means it's not going away anytime soon. Even then, Alliance Resource has the option to export its thermal and metallurgical coal to emerging markets with growing energy needs.
The final verdict: I'm calling this dividend legit and sustainable.
Annaly Capital Management: 11.6% yield
Another high-yield stock that's been making income investors drool with delight for years now is Annaly Capital Management. On a trailing 12-month basis, Annaly's yield has ranged between 9% and 16% since 2009. But what really matters is whether or not this high level of payout remains sustainable.
Annaly is part of a group of high-yielding companies in the mortgage real estate investment trust (REIT) industry, also known as mortgage REITs. Mortgage REITs make their money by using leverage and interest rates to their advantage. A company like Annaly purchases debt securities (e.g., mortgage-backed securities) and collects interest on that debt. Meanwhile, it borrows money at a short-term lending rate, allowing it to lever up and acquire more debt securities. The difference between the rate at which it borrows and the rate at which it collects on its owned debt securities is known as its net interest margin. The greater this spread, the more profitable the company.
The issue with Annaly often boils down to interest rates, since it essentially invests in agency-only loans -- this is a fancy of way of saying that it buys mortgage-backed securities that are protected by the federal government in case of default. If interest rates are falling, short-term borrowing costs decline, allowing for its net interest margin to increase. But when interest rates rise, short-term borrowing costs increase, squeezing this spread. In 2017, Annaly's net interest margin shrunk to 1.47% from 2.49% at the end of 2016.
To some extent, net interest margin also depends on Annaly's ability to adjust its leverage and portfolio holdings to a changing interest rate environment. The slower and more predictable these interest rate changes are, the better Annaly can prepare by adjusting its portfolio. Conversely, a rapidly rising rate environment can prove devastating to its margin spread.
The final verdict: I don't believe Annaly's $1.20 per share annual payout ($0.30 per quarter) is sustainable given the rising rate environment we're currently in. Then again, no senior management team is more skilled with managing mortgage-backed securities than Annaly's. I'd expect this dividend yield to remain high, but a sustainable 11% yield probably isn't in the cards.
GameStop: 11% yield
Brick-and-mortar gaming and accessory giant GameStop is another high-yield stock that'll turn heads. It's currently sporting an 11% yield ($1.52 per share a year), which works out to a payout ratio of less than 50% based on the consensus of $3.10 in EPS expected in the current fiscal year.
On the surface, it probably looks as if this dividend is safe, but GameStop is that stereotypical struggling business model described earlier that can lure in unsuspecting income seekers.
The issue here is that GameStop is primarily reliant on its legacy business model of selling physical games and accessories out of its brick-and-mortar locations. However, the gaming community has been transitioning for years to digital gaming, which can bypass physical stores altogether. In effect, GameStop is losing its niche as the gaming industry middleman.
This isn't to say that GameStop isn't focused on growing its digital sales, which increased by almost 14% in 2017 to $189.2 million. It's to point out that this $189.2 million pales in comparison to the $3.5 billion in total full-year sales in 2017. GameStop is essentially reliant on partnerships, mobile devices, and new consoles to drive its business. But even then, the sales pops have been few and far between, and its pre-owned sales segment, which typically generates its juiciest margins, shrunk by 4.6% in 2017.
Recently, GameStop's CEO laid out a five-point strategy to right the ship, so to speak. This strategy predominantly focuses on expanding its presence with hardcore gamers and casual consumers, cutting back on expenses and physical store expansion, and improving average transaction value. Of course these ideas sound great on paper, but with the industry moving steadily away from physical hardware, it's going to make GameStop's life more difficult with each passing year.
The final verdict: While GameStop's dividend might be safe for a few years, its weakening sales and declining EPS, even amid cost cutting, cannot be ignored. Over the long run, I do believe GameStop will have no choice but to reduce its annual payout.
Sean Williams has no position in any of the stocks mentioned. The Motley Fool owns shares of GameStop and has the following options: short July 2018 $14 calls on GameStop. The Motley Fool has a disclosure policy.