What's the first emotion you feel upon seeing a high dividend yield: greed or fear?
For me, it's greed. I'm not going to deny it. I love dividends, and the bigger, the better. There's nothing like getting a check every few months simply for investing money that'd otherwise sit idle. It's like having your cake and eating it, too.
Yet it's exactly this type of impulsive thinking which leads to losses, as the emotion which should be triggered by high dividend yields is fear. Like any other type of yield, a dividend yield communicates risk. The higher the yield, the higher the risk. After combing the exchanges for examples, I settled on the three stocks below to demonstrate this point.
1. Hudson City Bancorp (NAS: HCBK) Hudson City Bancorp is a New Jersey savings and loan institution yielding 5%. It's the second-largest publicly traded thrift in the country with $44 billion in assets. Its stock trades at a discount to book value, and according to its webpage the lender "has consistently been named The Most Efficient Bank in America."
With these particulars in mind, it's easy to understand why Hudson City's investor relations department would observe: "It's no wonder Forbes named Hudson City 'Among the Best-Managed Banks in America.'"
The only problem is that these accolades are four years old. In the intervening time period, the bank's rank and fiscal position have deteriorated markedly.
Return on Assets
Sources: Forbes' America's Best and Worst Banks and YCharts.com. *2012 rankings are expected later this year.
To add insult to injury, the bank has been operating under memorandums of understanding with both the Federal Reserve and the Office of the Comptroller of the Currency since the middle of last year. These understandings require Hudson City to rework the size and composition of its balance sheet and to obtain approval before "incurring any debt with maturity greater than one year ... declaring a dividend to shareholders ... or repurchasing ... Company stock." It's probably worth noting that these arrangements are often the kiss of death for both a bank's dividends and the underlying institution itself.
2. Annaly Capital Management (NYS: NLY) Annaly Capital Management is the biggest and best-known publicly traded real estate investment trust specializing in mortgage-backed securities. While Annaly's stock yields a ridiculous 13%, this figure is still less than the 15% yield of its fellow and operationally linked mREIT Chimera Investment (NYS: CIM) -- though, as Rich Smith noted, Chimera ominously informed investors that it will be restating financials for the past three years.
If you're not familiar with this type of investment vehicle, it's helpful to think of mortgage REITs as hedge funds that arbitrage interest rates. A typical mREIT raises money by issuing stock, leveraging the proceeds in the short-term credit markets, and then buying longer-term, higher-yielding mortgage-backed securities with the resulting capital. The earnings derive from the spread between short- and long-term interest rates.
Two weeks ago, Annaly reported second-quarter EPS of $0.55, comfortably beating the consensus estimate of $0.48 and just enough to maintain its dividend of $0.55. Yet despite this beat, shares slid a few cents. The reason? As my colleague Rich Smith noted, "Not everyone is convinced that Annaly's beat was all that met the eye."
The problem is that approximately $0.10 of the company's earnings per share related to one-time gains from the sale of securities. Without these gains, according to an analyst at Nomura Securities, Annaly's dividend is "not sustainable ... and further dividend cuts are possible."
While Annaly has dealt with this problem in the past by issuing stock and using the proceeds to bridge the gap -- just this year the firm's shareholders approved an additional issue of 1 billion shares -- it goes without saying that this business model isn't infinitely sustainable either. Just ask Bernie Madoff or Allen Stanford.
3. Frontier Communications (NAS: FTR) The last stock to make the list is Frontier Communications, a Connecticut-based telecommunications company. Founded in 1927, Frontier only recently became widely known after it purchased a large swath of Verizon's rural customer base in 2010, giving Frontier access to 4.8 million local access accounts, 2.2 million long-distance customers, and 1 million high-speed Internet customers.
While this transaction tripled Frontier's size, transforming the then-regional telecom into a national one overnight, it also nearly doubled the company's debt and increased its outstanding share count by a factor of 2.5. Then came additional consequences. At the beginning of this year, for instance, S&P downgraded Frontier's already junk-rated debt, and soon thereafter Frontier cut its dividend in half.
For a long time, the main concern was Frontier's dividend payout ratio -- the proportion of earnings or cash flow paid out as a dividend. In the second quarter of last year, for instance, the company paid out six times more in dividends than it recorded as net income and nearly 1.5 times its free cash flow. But as you can see below, this problem is now largely under control and indeed better than Frontier's competitor Windstream (NAS: WIN) , which has paid out a full 99% of its free cash flow in the first six months of 2012.
Free Cash Flow
The bigger concern now is whether Frontier will be able to profitably consolidate its hold over the newly acquired domain. In a recent in-depth report on the company, our senior analyst Dan Caplinger equates Frontier's challenge with that of FairPoint communications, which bought customer territories from Verizon in 2008 only to then collapse under the added weight one year later. And to make matters worse, this is only one of four major threats identified in the report!
High dividend yields: The bottom line
Look, nobody's going to blame or judge you for investing in one of the megayielders listed above. As I said at the beginning, I'm consumed by greed when I see dividend yields in these ranges. But if you do choose to invest in one of the three companies discussed above, it's important that you do so with full knowledge of the risk.
Quite simply, these three companies aren't rock-solid dividend stocks. For aggressive investors, they combine the benefits of a dividend stock with the risks of a highly speculative growth stock.
If you're comfortable taking on that kind of risk, then I suggest you read Dan's in-depth report on Frontier located here. But if you're like most dividend investors and aren't comfortable making speculative investments, then the rock-solid dividend stocks identified in our popular free report will be more to your liking.
The article 3 Dangerous Dividend Stocks originally appeared on Fool.com.
Fool contributor John Maxfield does not own shares in any of the companies mentioned above. The Motley Fool owns shares of Annaly Capital. Motley Fool newsletter services have recommended buying shares of Annaly Capital. The Motley Fool has a disclosure policy. We Fools may not 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.
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