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One tenet of value investing is seeking stocks with good dividend yields. But what a good yield means has changed over the years (See our article on dividend yields). The median yield of dividend-paying stocks in the Value Line Investment Survey was around 2% for the first half of 2010, with a low of 1.6% at the previous market high in July, 2007 and a high of 4.0% at the most recent low in March, 2009. Thus, a yield above 2% to 2.5% is good, and a yield above 5% is truly outstanding.

Value Line calculates its dividend yields using estimates of the year-ahead dividend payouts per share. This means that if you are reading a report in August 2010, which includes earnings results for the first half of the year, the dividend yield will be based upon the estimated dividend payouts in the third and fourth quarters of 2010 and the first and second quarters of 2011 (it is not based on the dividend payout estimated for 2010). With each subsequent report, the 12-month dividend estimate advances by one quarter. For the above example, in the next report, coming in October or so, the dividend yield would be based on the last quarter of 2010 and the first three quarters of 2011.

One implication of the fact that dividend yields are estimated is that the dividends on which they are based can fail to materialize. It is essential, therefore, for income-oriented investors to examine whether the payout that they hope to collect by buying a particular stock is secure or not.

Among the least secure dividends are those of investment companies like DWS High Income Trust (KHI) and American Capital, Ltd. (ACAS), which have changed their payouts, both up and down, multiple times over the last two years. American Capital completely eliminated its dividend in late 2008, paid one distribution in 2009 and is projected to pay out about $1.00 a share in 2010. Given the very low price of the equity, the yield would be attractive; however, investors should notice right away that the stock is ranked Below Average for Safety and is extremely volatile based on its high Beta coefficient. The company also has a low Financial Strength rating, a lot of debt, and potential liquidity issues. Thus, its dividend is not very secure. Should an investor buy ACAS at its current, very low, price, and should the company’s earnings recover, sustaining its dividend, then the investor will be getting a very handsome yield for his or her investment. But the investor must understand that such a scenario is far from assured. DWS High Income Trust is another company with an uncertain dividend. This equity has dropped its annual payout little by little every year since 2005 and in seven of the last nine years. The junk bond investment company carries a Below Average Safety rating, but its fiscal situation is somewhat better than American Capital. Nevertheless, investors buying this stock for yield are making a bet on the company’s turnaround prospects, which are at risk.

Other categories of high-yielding equities include a variety of tax-advantaged trusts and partnerships that are required to pay out a specified percentage of their income, cash flow, or “distributable earnings” to share- or unitholders as dividends or distributions. Perhaps the most well-known equities of this type are Real Estate Investment Trusts (REITs). In exchange for paying no corporate income tax, REITs must pay out 90% of their taxable income as dividends. REIT yields can vary, but generally range between 3% and 8%. REIT distributions have historically been somewhat more secure than those of investment companies, although the real estate meltdown of 2007-2009 has somewhat undermined that record. Selections that stand out for relatively secure dividend yields in this group are HCP, Inc. (HCP), Hospitality Properties Trust (HPT), Mack-Cali Realty (CLI), Realty Income Corporation (O), Washington REIT (WRE), and Weingarten Realty (WRI), all of which are ranked Average, or better, for Financial Strength.

Similar to REITs are a group of natural resource companies called Master Limited Partnerships (MLPs). Like REITs, MLPs do not pay corporate income taxes and must pay out a specified percentage of their income in the form of a unit distribution, which is similar in most respects to a dividend. Unlike REITs, MLPs have certain tax advantages, which allow individual investors to defer tax on about 80%-90% of the distribution, usually. Yields for this group of equities have been even steadier than those for REITs, because the companies, which are almost all engaged in natural gas and oil pipelines and compression facilities, are not affected by ups and downs in commodity prices; they simply charge a toll for the use of their services and are benefitting from the secular growth in energy use and corresponding infrastructure expansion. The following MLPs have Financial Strength ratings of Average, or better, and have not reduced their distribution since going public or in the last nine years (at least): Buckeye Partners (BPL), Energy Transfer Partners (ETP), Enterprise Products Partners (EPD), Inergy (NRGY), Kinder Morgan Energy Partners (KMP), Magellan Midstream Partners (MMP), and Plains All American Pipeline (PAA). One note of caution on these equities, however, is in order: investors seeking yield have bid up the price of these units (shares) considerably in the last year or so and they may be somewhat overvalued in the case of individual companies.

A number of other miscellaneous companies operate with a limited partnership structure and pay sometimes generous distributions, including securities brokerage firm BGC Partners (BGCP), death care service provider StoneMor Partners (STON), and private equity group Blackstone Group (BX). The partnership structure of these companies varies, as does the security of their dividend payouts. BGC Partners, to choose one example, aims to pay out 75% of its “post-tax distributable profits,” defined as GAAP net profit excluding non-cash equity compensation, allocation of net income to founding or working partner units, non-cash asset impairments, and charges related to partnership unit redemptions. The result, in BGC’s case, is that its dividend growth or shrinkage will correlate strongly with the company’s growth or shrinkage in cash flow. Investors chasing BGCP’s high yields should thus be aware that a reversal in the company’s earnings prospects, and not just a deterioration in its fiscal position, would put the stock’s dividend, and high yield, in jeopardy.

Investment companies, REITs, MLPs, and limited partnerships all potentially deliver handsome dividend/distribution yields to investors. However, as discussed above, the yields of all these investment categories are, to differing degrees, more or less secure insomuch as they are more or less directly tied to their companies’ earnings or cash flow.

For investors looking for better-than-average yields that are more secure than those of the investment categories discussed above, one traditional route has been to invest in power or telecommunications utilities. Utilities generally operate in regulated sectors, with very steady income, which they pay out regularly. Utilities with Above Average Safety ranks and above 5% yields include CH Energy Group (CHG), Consolidated Edison (ED), Exelon Corporation (EXC), and Southern Company (SO). Investors should beware, however, of power companies that have both regulated and non-regulated segments, such as Constellation Energy (CEG); such equities are usually more volatile in price and have less secure dividends. 

One final group of stocks that has above-average dividend yields is that of very solid blue-chip companies such as Coca-Cola (KO – Free Analyst Report), Johnson & Johnson (JNJ – Free Analyst Report), McDonald’s (MCD – Free Analyst Report), and Bristol-Myers Squibb (BMY). Such companies have very strong Financial Strength ratings and thus ample liquidity to fund or even increase their existing dividend payouts. It should be noted, however, that these very safe equities, with their very well-covered dividends, also have the least attractive yields of all the equities discussed so far (around 3%-4%).

All told, investors seeking income would do well to construct a portfolio that mixes some or all of these high-yielding stocks. Those with an appetite for more risk might give greater weight to dividend growers like BGC Partners; those looking for more steady income would likely opt for a mix of utilities and blue-chip earners.