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) 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:

Bowater is a leading producer of newsprint. Unfortunately, that's a declining industry, as evidenced by the weakening financials at New York Times (NYSE:NYT), Gannett (NYSE:GCI), and Tribune (NYSE:TRB). Bowater's income continues to shrink, there's a lot of debt on the balance sheet, and the industry doesn't look to be turning the corner. That's a recipe for a dividend in danger.

TSR is a tiny computer services company operating out of the Northeast. It's incredibly cheap, but current income can't cover the dividend, and the company is facing the loss of a big customer -- the New York Department of Education. While the company does have more than $8 million in cash, this is a dividend that may not hold on for long.

High-yield opportunity
The story behind Motley Fool Income Investor-recommended Enterprise Products Partners is far more interesting. First, the company operates as a master limited partnership (MLP), which means that it does not pay any taxes at the corporate level. Rather, its gains pass through to shareholders in the form of outsized dividends.

Enterprise owns thousands of miles of onshore and offshore pipelines and gets paid whenever an oil or gas company uses Enterprise's infrastructure to transport its product. This means that Enterprise has benefited greatly from increased energy demand, but it doesn't suffer as much when prices move up and down.

Sounds like a good deal, right? It is, but because EPD operates as an MLP, is grouped together with the volatile energy sector, and is extremely capital intensive, the stock price has not grown with in step with the underlying business. That's why we have the outsized yield today.

Foolish bottom line
Enterprise Products Partners may be a bit complicated, and energy demand is certainly a risk. But if it were clear cut, the big yield wouldn't be there. Yields decline as prices rise, and an easy 7% return in an efficient market is like a wounded tuna to a shark -- it won't last long.

There's great potential reward in doing the due diligence on a company like Enterprise Products. For more of the inside track on the best and biggest yields the market has to offer, a 30-day guest pass to Income Investor is available gratis. 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 does not own shares of any company mentioned. No Fool is too cool for disclosure ... and Tim's pretty darn cool.