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High Yield Dividend Stocks

The Risk and Reward of Dividend Investing

Written by Briton Ryle
Posted March 6, 2014

There’s a lot of money to be made on the stock market. You buy a stock low, wait for it to run up, and then sell high to lock in a nice capital gain. It’s what most people think of when you mention stock market investing.

But there’s another means of generating profit from stocks with a distinct advantage over capital gains: dividends – the regular payouts a company pays to its stockholders.

Their advantage? While locking in a capital gain requires the market to move in a particular direction (up if you’re long, down if you’re short), earning income from dividends requires no market movement at all – only the passage of time.

You can maximize the value gained from the time you spend waiting by investing in high yield dividend payers. In fact, they can double or even triple your income. Where most blue chip stocks offer dividend yields of some 2 to 4 percent per year, high yield stocks can pay over 10 percent - paying you an entire year’s worth of the average dividend in just one single quarter.

That’s pretty easy. Since time ticks away in all market cycles – bull, bear or stagnant – dividends will give you steady profits without us having to think about what the market is going to do next. You just have to count the days until your next payout.

There’s just one critical thing to note about high yielders which can make or break your entire investment… the dividend’s sustainability.

The Dividend’s Risk

Even though profit can be earned from dividends regardless of market direction, it isn’t entirely free from risk. There always exists the clear and present danger that the dividend will be reduced or even cancelled.

To makes matters worse, a reduced or cancelled dividend will not only slash the income you were counting on, but will also wipe out a large amount of the capital you have invested. A stock’s price is elevated by the anticipated dividend. Should that dividend be cut at some point, you can bet traders will adjust the price of the stock to a lower value inline with the lower dividend payout.

So what good is it to gain 10 percent in dividends one year only to lose 20 or 30 percent of your entire capital investment the next? As a case in point, simply have a look at Great Northern Iron Ore Properties (NYSE: GNI), a royalty trust that owns and leases mineral and non-mineral properties in the Mesabi Iron Range of Minnesota.

For years GNI has consistently paid dividends of $2.50 per quarter, or $10 annually. But in just the first week of January, its stock plummeted from $67 a share to $23 for a loss of 65 percent. That represents more than 4 years’ worth of dividends wiped out of your capital investment in just one week. Ouch! That smarts!
Trading at just over $21 per share today, GNI’s dividend yield has shot up to over 49 percent! Time to buy now?

Nothing doing. Dividend investors need to look past the high yield number and spot the reason behind it. The plunge took place after the last dividend payout in December, and the yield is calculated using the last dividend payment of $2.50, or $10 per year.

Since the company has revealed it will be closing down shop in 2015, it is extremely unlikely that dividends will remain at $2.50 between now and then. That 49 percent yield you see printed across the top of GNI’s graphs is unsustainable, and we had better look elsewhere.

For this reason, investors must always look at a company’s cash flow. Does the company generate enough free cash after all operating and debt expenses to sustain its high dividend well into the future?

Since cash flow is the key, let’s take a look at an industry that just gushes cash like oil from a well, and overflows with money like gas down a pipeline. Let’s look at two high yield picks from the oil and gas industry.

SeaDrill Ltd (NYSE: SDRL)

Publicly traded since mid-2010, Seadrill Limited provides offshore drilling services to the oil and gas industry worldwide. In addition to drilling, building and maintaining offshore exploration and production wells, it also operates self-erecting tender barges and semi-submersible tender rigs used for production drilling and well maintenance. The company owns and operates a fleet of 66 offshore drilling units, including 15 semi-submersible rigs, 1 drillship, 24 jack-up rigs, and 16 tender rigs.

The $16.99 billion large cap has consistently raised its dividend from 3 to 4 cents each of the past four quarters, with its last payout of 98 cents per share equating to an annual yield of 10.82 percent. That’s over 4 times Exxon Mobile’s (NYSE: XOM) dividend yield of 2.69 percent.

SeaDrill’s annual revenues at $5 billion is some 29.4 percent of its market cap, falling well short of Exxon’s stellar 97 percent of revenue over market cap. While SeaDrill’s return on assets of 5.54 percent falls short of Exxon’s 8.04 percent, its return on equity at an amazing 39.17 percent screams past Exxon’s 19 percent.

SeaDrill is also growing its revenues far faster than Exxon is, at 24.5 percent quarterly revenue growth over Exxon’s shrinkage of -2.9 percent. SeaDrill’s net income available to common stock holders of $2.65 billion at 53 percent of its revenues pummels Exxon’s income to stock holders of $32.58 billion or only 8.27 percent of its revenues, indicating that SeaDrill rewards its shareholders with greater equity growth. And remember that this is in addition to an annual dividend yield that is 4 times greater.

As for that all-important cash flow for dividend sustainability, SeaDrill has an operating cash flow of $1.7 billion or some 10 percent of its market cap, compared to Exxon’s operating cash flow of 11 percent of its market cap.

SeaDrill’s dividend thus secured, analysts surveyed by Yahoo! Finance give the company’s $36.22 stock a low target of $32, a mean target of $43.14, and a high target of $53 – representing a capital appreciation potential of 46.3 percent, compared to Exxon’s projected high target growth potential of 19.4 percent.

LRR Energy (NYSE: LRE)

Founded in 2011, Houston, Texas-based LRR Energy engages in acquiring, developing and operating oil and natural gas properties in North America, including numerous interests in the Gulf Coast, west Texas, New Mexico and Oklahoma. It has estimated proved reserves of approximately 28.8 million barrels of oil equivalent, worth some $3 billion at today’s prices.

The $457 million small cap has consistently raised its dividend a quarter of a cent each quarter, with its last payout of 49 cents per share equating to an annual yield of 11.21 percent. That too is over 4 times Exxon’s dividend yield of 2.69 percent.

LRR’s annual revenues at $95.22 million is some 20.8 percent of its market cap, also well short of Exxon’s 97 percent of revenue over market cap. LRR’s returns on assets and equity of 2.38 percent and 5.96 percent respectively also pale in comparison to Exxon’s 8.04 percent and 19 percent.

But LRR makes up for it in its quarterly revenue growth of 11 percent, far better than Exxon’s shrinkage of -2.9 percent. LRR’s net income available to common stock holders at $12.85 million is 13.5 percent of its revenues, beating Exxon’s 8.27 percent, indicating that like SeaDrill, LRR also rewards its shareholders with greater equity growth, which similarly comes in addition to an annual dividend yield that is more than 4 times greater than Exxon’s.

Does LRR have enough cash flow to sustain its dividend? It certainly does, with an operating cash flow of $58 million or some 12.7 percent of its market cap, compared to Exxon’s operating cash flow of 11 percent of its market cap.

LRR’s dividend equally secured, analysts surveyed by Yahoo! Finance give the company’s $17.48 stock a low target of $15, a mean target of $17.88, and a high target of $20 - representing a capital appreciation potential of 14.4 percent over current prices.

When looking for returns that are not market dependent, dividends have the advantage of being based on time rather than on market direction. Even so, one should always be careful to analyse a company’s ability to keep paying its dividends. Ensuring sufficient cash flow, low debt and continued revenue growth will keep those dividend dollars flowing for years to come.

LRR Exxon ChartClick Here to Enlarge

Source: BigCharts.com

Joseph Cafariello

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