Hit the High-Yield Jackpot

Editor's note: The prior version of this article incorrectly implied that Lear continued to pay a dividend. Lear suspended its dividend last week. We regret the error.

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) 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:

Both Lear and American Axle count Ford (NYSE:F), General Motors (NYSE:GM), and DaimlerChrysler (NYSE:DCX) as major customers. As those companies find themselves in tough spots -- with stagnant revenues and growing obligations -- so, too, do Lear and American Axle.

Yet, American Axle continues to pay a regular dividend and Lear just suspended its dividend last week. The question is: How much longer can American Axle last and why didn't Lear suspend sooner? It's been a year since Lear posted a profit, and while American Axle is still profitable, it's making less and less and expending more and more.

High-yield opportunity
The story behind Motley Fool Income Investor-recommended American Financial Realty is far more interesting. The real estate investment trust (REIT) sector has seen yields decline as major players such as Liberty Property Trust (NYSE:LRY) drastically outpace the market. Since the company operates as a REIT, American Financial's payout is necessarily high. But when analyzing REITs, the key statistic is funds from operations (FFO), not FCF or net income. To calculate FFO, add back depreciation and amortization (which are often high, since REITs deal in real estate) to net income. 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 board members were also buying shares in November at today's price.

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 General Electric's (NYSE:GE) 2.9% yield and 59% payout ratio, 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. 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.