Having invested in the stock market for 20 years now, I've learned one valuable lesson: The best portfolios are almost always filled with high-quality dividend stocks. Aside from the fact that dividend stocks outperform their nondividend-paying brethren over the long run, the former offer a bevy of advantages to investors.
The give-and-take of high-yield investing
To start with, a company that pays a regular dividend is sending a message to Wall Street and investors that it has a time-tested business model capable of consistently generating profits. It's unlikely that a board of directors would share a percentage of a company's income with investors if that board didn't foresee many more years of healthy profits and/or growth.
Secondly, dividends are great for helping to partially offset the inevitable declines associated with stock market corrections and bear markets. Even though stocks spend far more time in a bull market than in correction, downside at some point in the future is inevitable. Dividends can help lessen the magnitude of this downside.
And, perhaps most importantly, a regularly paid dividend can be reinvested back into more shares of dividend-paying stock. This can lead to successively more shares of stock being owned, and larger dividend payments being received, in a repeating pattern. This "trick" is what most money managers lean on to pump up the long-term returns of their clients.
But therein lies the rub with dividend stocks: We want the highest yield possible, but with virtually no risk. Unfortunately, yield and risk tend to go hand in hand. In other words, the higher the yield, the more likely it proves unsustainable.
One of the key reasons this is the case is because yield is a function of price. If, for instance, a publicly traded company's share price is halved, its dividend yield will double, probably making it more attractive to income-seeking investors. But if there's an underlying issue with the company's business model, a growing yield may prove to be nothing more than a trap for income investors.
In short, investing in high-yield dividends -- traditionally defined as those with an annual yield of at least 4% -- requires extra scrutiny on the part of investors.
It's time to sell this 17% yield stock
As a case in point, consider BP Prudhoe Bay Royalty Trust (NYSE:BPT), which is currently paying out an extrapolated $5.10 a year, based on the $1.275 per share it divvied out in April. This is good enough for a better than 17% annual yield, albeit it should be noted that the Trust's payout differs each quarter depending on its royalty revenue and cash earnings.
Generally speaking, a 17% yield is mouthwatering. At this rate of return, reinvesting your dividends should, in theory, lead to a complete repayment of your initial investment in less than five years, assuming the share price remains static. But BP Prudhoe Bay Royalty Trust is one of those aforementioned yield traps that investors should probably consider running away from.
The Trust's business model is very straightforward. It receives a percentage of production from BP's (NYSE:BP) Prudhoe Bay Alaska operations. This percentage is capped to the first 90,000 barrels per day of production. Given that the Trust's costs tend to be predictable -- concessions to BP and administrative expenses represent the bulk of its costs -- BP Prudhoe Bay Royalty Trust's dividend tends to be intricately tied to the price of oil. If West Texas Intermediate (WTI) significantly increases in price, then the Trust's ability to net more in cash earnings allows it to pay a beefier dividend.
Though consistently rising WTI prices have helped lift the share price and aggregate payout of the Trust in recent quarters, there are still reasons for investors to be concerned. For example, the Trust is only expected to last through 2028, whereupon the share price will effectively head to $0 (although this termination date has been fluid in recent years). This means investors have to hope they'd receive more in aggregate dividends between now and 2028 in order to walk away having made money. That might seem easy to do with a greater than $5 annual extrapolated payout, but keep in mind that production is starting to fall.
According to BP Prudhoe Bay Royalty Trust's 10-Q filing, average net production during the first quarter was just 84,000 barrels per day (bpd), down from 91,800 bpd in the year-ago quarter. What's more, the Trust has consistently produced less than 90,000 bpd annually since 2015, and anticipates that production will come in below this level on an annual basis "in most future years." This means that WTI would probably need to rise significantly in order to make this Trust a viable intermediate-term investment -- and, frankly, I don't have that type of confidence.
And, as icing on the cake, weaker crude prices in March 2016 coerced BP to reduce its rig count in Prudhoe Bay by more than half to just two rigs. This looks to be a high-yield income stock to avoid.
This 11% yield looks mighty attractive
On the other hand, there are companies with a double-digit dividend yield that are legitimately attractive and probably sustainable. Instead of looking at BP Prudhoe Bay Royalty Trust, I'd suggest sticking within the commodity arena and considering coal producer Alliance Resource Partners (NASDAQ:ARLP), which is currently yielding 11.5%.
I know what you're probably thinking: "Isn't coal going the way of the dodo bird?" While you are correct that coal has lost substantial ground to cleaner-burning natural gas and has seen renewable energies like solar and wind begin to claw their way up the ranks, it's not exactly a source of energy that's at risk of disappearing anytime soon -- especially with oil and natural gas now well off their 2016 lows. According to the U.S. Energy Information Administration, 1.2 billion kilowatt-hours of electricity was generated with coal in 2017, working out to a 30.1% share. That trailed natural gas (31.7%), but was ahead of nuclear (20%) and all renewables combined (17.1%). In other words, coal remains relevant, even if lacks the flare of renewable energy.
What makes Alliance Resource Partners so special is the company's focus on the future, as well as its balance sheet.
When I say "focus on the future," I have two specific meanings. First, the company does an excellent job of locking in volume and pricing commitments for the future. As of the end of its most recent quarter, it had 38 million tons of secured volume and price commitments in 2018 to go along with 17.5 million tons, 11.7 million tons, and 4.8 million tons, in 2019, 2020, and 2021, respectively. For added context, the company expects coal production volume of 40 million tons to 41 million tons in 2018. Securing deals well in advance ensures predictable cash flow and minimizes the company's exposure to wholesale fluctuations in the price of thermal and/or metallurgical coal.
But I also refer to Alliance Resource Partners' export push when I reference its "focus on the future." In 2018, 7.1 million tons of its 38 million in secured volume is headed overseas -- a new record. Last year, it shipped 6.3 million tons to international markets, most of which was thermal coal. Developing overseas markets are likely to be reliant on coal for decades after the U.S. pushes toward renewable reliance, meaning Alliance Resource Partners is angling to secure its position as a global export leader.
Finally, the company's balance sheet is in far better shape than its debt-riddled peers. With less than $480 million in net debt, the company's 40% debt-to-equity ratio gives it the financial flexibility to make acquisitions, or adjust its output, as management sees fit.
While coal may not be an ideal industry to look for a solid dividend stock, I believe you'd struggle to find a company with a yield north of 10% that's more promising than Alliance Resource Partners.