In most cases, dividend stocks form the basis for a successful long-term investment portfolio. They also tend to significantly outperform stocks without dividends over time.
But beyond sheer outperformance, dividend stocks bring three benefits that investors appreciate. First, dividend stocks generally have proven business models and relatively clear long-term prospects – otherwise they would not share a percentage of their profits with shareholders. Second, dividend payouts serve to partially hedge against the inevitable "turbulence" in the stock market. Finally, dividends can be reinvested in more stocks that pay dividends, which increases your ability to build wealth.
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The great dividend riddle
But the dividend also offers investors quite a conundrum: we want the highest possible yield, but we also want a sustainable payout over a long period of time. The higher the yield, the more difficult it might be to maintain this level. Remember that the dividend yield depends on the total payout and the stock price. For example, if a company's underlying business model runs into trouble and the stock price drops by 50%, the dividend yield doubles, which could be dangerous for unsuspecting investors.
This battle between our good judgment and our desire for the highest possible return is often most fiercely fought in dividend stocks with double-digit yields. There are currently about 100 publicly traded stocks that pay dividends of more than 10% each year, although that number may include one-time special dividends from the previous year.
Are these dividends sustainable?
Three high-yielding stocks in this group of about 100 publicly traded companies caught my eye: Alliance Resource Partners (WKN:925301), Annaly Capital Management (WKN: 909823) and GameStop (WKN:A0HGDX). The big question is: Are their 11% dividend yields sustainable, too?
Let's take a closer look.
Alliance Resource Partners: 11.9% yield
Before you take flight, let me be clear: Yes, Alliance Resource Partners is a coal producer. And yes, coal producers are not doing well at the moment. But Alliance Resource is not like its peers.
The first difference is evident in the company's balance sheet. The company's latest quarterly results, released Monday, showed $28.8 million in cash and cash equivalents and a subsequent $29.2 million reduction in long-term debt. While most of the company's competitors carry about $1 billion or more in long-term debt, Alliance Resource Partners is well below that amount, giving it the financial flexibility to close deals and match production to demand. Many competitors simply do not have this luxury.
Alliance Resource Partners has also done a remarkably good job of minimizing its exposure to wholesale coal prices by securing supplies well in advance of the event. CEO Joseph Craft III, "During the quarter, ARLP contracted to deliver up to 19.7 million tons from 2018 to 2022, including an additional 4.8 million tons delivered this year". This additional utilization in 2018 even led the company to increase its full-year production guidance to a new output of 40 million to 41 million tons of coal, representing 8% year-over-year growth. More than 17 million tons are budgeted for 2019, and nearly 12 million for 2020.
Although coal is sure to face opposition, it still accounts for about 30% of total electricity production in the U.S., which means it's not going away anytime soon. In addition, Alliance Resource has the opportunity to export its thermal and metallurgical coal to emerging markets with growing energy needs.
The final verdict: I call this dividend solid and sustainable.
Annaly Capital Management: 11.6% return on investment
Another high-yield stock that has excited investors for years is Annaly Capital Management. On a 12-month basis, Annaly's returns have ranged from 9% to 16% since 2009. The key, however, is whether or not this high payout ratio remains sustainable.
Annaly is one of a group of high-yield companies in the mortgage real estate investment trust (REIT) business, also known as mortgage REITs. Mortgage REITs make their money by using debt and interest to their advantage. A company like Annaly buys debt securities (z.B. mortgage-backed securities) and collect interest on those notes. In the meantime, the company borrows money at a short-term interest rate, which allows it to purchase more debt instruments. The difference between the interest on the loan and the interest received is called the net interest margin. The bigger the company, the more profitable it is.
The company invests primarily in mortgage-backed securities that are protected by the government in the event of a default. When interest rates fall, short-term borrowing costs fall, so net interest margin rises. But when interest rates rise, short-term borrowing costs rise, putting pressure on the spread. In 2017, the net interest margin fell from 2.49% at the end of 2016 to 1.47%.
To some extent, net interest margin also depends on Annaly's ability to adjust debt and portfolio to a changing interest rate environment. The slower and more predictable these interest rate changes are, the better Annaly can adjust to them. Conversely, a rapidly rising interest rate environment can prove devastating to margins.
The final verdict: I don't think Annaly's annual payout of $1.20 per share ($0.30 per quarter) is sustainable given the rising interest rate environment we are currently in. On the other hand, no management is more familiar with the management of mortgage-backed securities than that of Annaly. I would expect this dividend yield to remain high, but a sustainable yield of 11% is probably not in the cards.
GameStop: 11 % return
Games and accessories giant GameStop is another revenue-generating title that will raise eyebrows. Currently, the yield is 11% ($1.52 per share per year), which is a payout ratio of less than 50%, based on the expected dividend income of $3.10 for the current fiscal year.
On the surface, it probably looks like this dividend is safe, but GameStop is the stereotypical business model described earlier that can attract unsuspecting investors.
The problem is that GameStop relies primarily on its old business model of selling physical games and accessories in its stores. However, the gaming community has been transitioning to digital gaming for years, which can bypass physical stores entirely. In reality, GameStop is losing its niche as a game industry intermediary.
That's not to say GameStop isn't focused on growing its digital sales, which increased nearly 14% in 2017 to $189.2 million. It should be noted that this $189.2 million is quite puny compared to the $3.5 billion in total annual revenue in 2017. GameStop essentially relies on partnerships, mobile devices and new consoles to drive its business forward. But even with that, sales were very low, and the secondhand sales segment, which typically generates the highest margins, shrank by 4.6% in 2017.
Recently, GameStop's CEO developed a five-point strategy to get the ship back on course, so to speak. This strategy focuses primarily on expanding its presence among hardcore gamers and casual customers, reducing costs and expanding physical stores, and improving average transaction value. Of course, these ideas sound great on paper, but as the industry continues to move further away from physical hardware, GameStop will have a harder time with each passing year.
The final verdict: While GameStop's dividend may be safe for a few years, weakening sales and declining earnings per share, even with cost savings, cannot be ignored. In the long run, I believe GameStop has no choice but to reduce its annual payout.
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The Motley Fool owns shares of GameStop and has the following options: Short July 2018 $14 calls on GameStop.