Indiscriminately investing in high-yield dividend stocks can be quite risky. This can be explained by the old adage: If it's too good to be true, it usually is.
Dividend stocks with high-yields are often yield traps. This means that the dividend is high because the stock has plunged or the payout is at risk of being cut or even suspended. The reasons for dividend cuts or suspensions can include high debt loads and declining profitability.
But every now and then, there are exceptions to the rule. Main Street Capital (MAIN -0.85%) and Prudential Financial (PRU -0.23%) appear to be offering safe, market-beating dividends to income investors. Let's dig a little deeper into why each of the two stocks could be smart buys for investors with some capital to invest.
1. Main Street Capital: A best-of-breed BDC
Main Street Capital is a business development company (BDC). These types of companies invest in other companies that generally don't have the ability to secure financing in traditional ways, such as via a bank loan or selling bonds.
Main Street Capital focuses on the underserved lower-middle market. These are companies with annual revenue between $10 million and $150 million and earnings before interest, taxes, depreciation, and amortization (EBITDA) of $3 million to $20 million. The BDC in exchange for extending credit takes significant ownership stakes in these companies and/or receives above-average interest income.
With $4.5 billion in capital under management internally, Main Street Capital is highly diversified. As of Sept. 30, the company had debt and/or equity investments in 195 companies. The biggest individual investment in the portfolio accounted for 3.3% of Main Street Capital's total investment income and 3.2% of the total portfolio's fair value. Given that the company's highest industry exposure was just 8%, to the internet software and services industry, the BDC is also well diversified across dozens of industries.
BDCs are able to avoid corporate tax as long as they distribute a minimum of 90% of their taxable income to shareholders. This explains how Main Street Capital is able to offer investors a market-trouncing 7.4% dividend yield, which is more than quadruple the S&P 500 index's 1.7% yield.
Since it became a publicly traded company in 2007, the BDC's monthly dividend per share has soared 105% to $0.225. With the dividend payout ratio coming in at 91.7% over the last 12 months, Main Street Capital should be able to continue handing out slow and steady dividend raises moving forward.
The icing on the cake is that the stock is attractively valued. At the current $37 share price, Main Street Capital is trading at a trailing-12-month price-to-earnings ratio (P/E) of just 11.5.
2. Prudential Financial: A solid insurer and asset manager
As long as there have been equity markets, there have been asset managers. And with $1.35 trillion in assets under management as of Sept. 30, Prudential Financial is among the largest players in the industry. And if the company's leadership status in the asset management industry weren't enough, Prudential also is a dominant life and disability insurer: It is the second-biggest insurer in the U.S. based on net premiums written.
An investment in Prudential is a twofold bet. First, that institutional investors, such as pension funds and mutual funds, and retail investors will demand asset management services in the years ahead. Second, that employers and individuals will keep purchasing life and disability insurance policies. These are arguably pretty safe bets for the future.
With the dividend payout ratio set to come in at around 50%, this makes the generous 4.7% dividend yield quite safe. And at the current price of about $101 a share, income investors can snatch up shares of the stock at a forward P/E ratio of 8.6. For context, this is meaningfully below the asset management industry average forward P/E ratio of 14. By any measure that makes Prudential a bargain.