Dividends as far as the eye can see
How could I resist? I love dividends as much as the next guy does, and Allied Capital had one of the best payouts going, regularly clocking in at yields of 10% or more.
In the late 1990s, I had some investment cash burning a hole in my bank account. Dousing the flames with a nice dividend payer was the way to go, I reasoned, and I pumped a lot of that money into the company's stock.
The underlying fundamentals appeared to be sound. Allied was one of the best business-development companies, or BDCs, out there, plying their trade and producing good returns since the early 1960s. What's more, it'd been paying those dividends -- fat ones! -- since that time, and those payouts stayed at the same level or increased in every subsequent quarter. By the time I started to put my money in Allied, that winning streak had been cranking for nearly 40 years.
The stock market is fluid, and even the best companies have bad quarters and cut dividends. But not my Allied Capital; it was as strong and durable as its name implied. Nothing could possibly go wrong.
Things went wrong
It all hummed along for a little while. Allied made its loans and collected its fees, paying out nearly all of its profit to shareholders like me (as required by law for BDCs).
Then the century turned, and troubling news items crept up now and again. There were the whispers about the propriety of a newly acquired subsidy, whispers that grew louder when the government made the unit the target of an investigation. Around that time, a crazy hedge-fund manager named David Einhorn got the idea that Allied was essentially cheating in the way it valued its illiquid securities. Einhorn was a notorious short-seller; obviously, thought I and many other unwisely optimistic Allied investors, he wanted to make a buck by driving the stock price down.
Einhorn bothered the SEC enough for the sleepy watchdog to launch an investigation of Allied. Actually, "investigation" is probably a strong word for the SEC's limp attempt; in the 18 months it was theoretically sniffing around the company, not once did it pay a visit to its office to grill any executives. Rather, it launched a probe into Einhorn's business activities. Meanwhile, Allied's nice dividend payouts continued, so we closed our eyes and took the money.
The credit crunch reared its ugly head, but our favorite BDC's operations seemed largely unaffected. By then, however, Einhorn's criticisms had found a big audience, and the market started to have serious doubts about Allied. The share price fell and then dropped off a cliff in 2008, when one of the company's portfolio investments, a firm called Ciena Capital, declared bankruptcy. Oops.
Finally, Allied put itself on the block and out of its misery. The buyer was Ares Capital
Maybe that Einhorn guy wasn't so crazy after all.
The Allied debacle wasn't a lesson or lessons; it was a school. My takeaway from the first of many classes was that if there's even a hint of improper conduct at a company whose stock I own, at the very least I owe it to myself and my family to look into it. The "shut your eyes and take the money" approach has the strong potential to lead straight to disaster. Secondly, if a company is obfuscating or dead quiet about one or more of its questionable operations, I need to immediately figure out the possible reasons why ... and unless they're solid, I should get out of the stock.
No. 3 is probably the most important lesson -- never be swayed by a high dividend yield alone. There are many examples of companies that not only spit out an unsustainable payout, but also wear it as camouflage to mask a rotten operation.
Exhibit A, B, and C: Allied Capital.
Fool contributor Eric Volkman still owns shares of Ares Capital. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.