Hit the High-Yield Jackpot

Stocks with high dividend yields can do wonders for a portfolio. If you buy shares of a company that pays 6%, 8%, or even 10% annually and get a capital gain, you're pretty much assured of beating the market.

The problem is that high yields also tend to be unreliable.

High-yield headaches
High-yield stocks are only worthwhile when investors receive the advertised return. As valuation luminary Aswath Damodaran told Fool co-founder Tom Gardner in a recent interview, "High-yielding stocks are [only] attractive if you can expect the company to keep paying those dividends."

How do Fools separate jackpots from time bombs? Cash. Is the company generating enough free cash flow (FCF) from operations to cover its dividend? Or is it borrowing money or using one-time gains (such as selling assets) to meet obligations? If it's the latter, a cut could be in the making. Here are three companies currently paying more than they earn:

PXRE Group is a Bermudan reinsurer that recently announced enormous losses from Hurricanes Katrina, Rita, and Wilma. Because of its accumulated deficit, the company is no longer able to pay a dividend under Bermuda law. While the company has not commented on the resumption of its dividend in the future, the supposed 15.1% yield does not exist.

Synagro Technologies is in a different situation. While the company posted a loss over the trailing 12 months, it recapitalized its balance sheet and seems to think it has its fiscal house in order. The risks, however, lie in the fact that the company has not been able to meaningfully grow revenue over the past two years, while its nearly $250 million long-term debt position remains frighteningly high.

High-yield opportunity
The story behind American Financial Realty, which is a Motley Fool Income Investor-recommended real estate investment trust (REIT), is far more interesting. The REIT sector has seen yields decline, as major players such as Boston Properties (NYSE:BXP) and TrizecProperties (NYSE:TRZ) drastically outpace the market. Since the company operates as a REIT, its payout is necessarily high. But when analyzing REITs, the key statistic is FFO (funds from operations), not FCF or net income. To calculate FFO, add back depreciation and amortization to net income -- a number that is often high since REITs deal in real estate. But American Financial goes a step further and reports Adjusted FFO (AFFO) to account for non-core property sales. These transactions enhance the reliable stream of income the company receives from mostly A- (or better) credit-rated financial institution tenants. In 2005, American Financial had AFFO of approximately $134.4 million -- enough to cover the $132.1 million in dividend payments it had to make.

Can the company stay ahead of its obligations? Management seems to think so. Recent guidance shows that the company will cover its dividend in 2006, and management is adamant that the dividend is not in danger. The CEO and chairman also bought shares recently.

Most analysts and investors, however, seem to disagree. The stock price has dropped substantially since 2004 and now trades some 20% below the 2003 IPO price. That's why we have the outsized yield today.

Foolish bottom line
AFR is not a clear-cut play. But if it were, the big yield wouldn't be there. Yields decline as prices rise, and a reliable 9% yield in an efficient market is like a wounded tuna to a shark -- it won't last long.

You can always stick with the conservative and covered yields like Whirlpool's (NYSE:WHR) 1.9% yield and 28% payout, or Deere's (NYSE:DE) 2.0% yield and 22% payout, or United Parcel Service's (NYSE:UPS) 2.0% yield and 42% payout, but the potential reward isn't as great as doing the due diligence on a company like American Financial. A 30-day free trial to Income Investor, on the other hand, will give you the inside track on the best and biggest yields the market has to offer, including two of the market's most overlooked REITs. The secret is cash -- and the cash can be yours. Click here to learn more.

This article was originally published on Jan. 6, 2006. It has been updated.

Tim Hanson owns shares of American Financial Realty. No Fool is too cool for disclosure ... and Tim's pretty darn cool.