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Looking for the "next big thing?" This type of search usually leads most investors to seek out high-tech companies and risky "concept" stocks with little to no earnings. However, the reality is that you don't need to invest in uncertain companies and take unnecessary risks in order to earn above-average returns. Instead, history has shown that dividend-paying stocks perform better than just about any other investment class available. In many cases, these unloved stocks are where investors are most likely to reap the best returns -- particularly in flat to down markets like we've seen recently. Statistics show that not only do dividend payers outperform non-payers by a wide margin, but high-yield stocks also outpace their low-yield brethren over the long haul. With this in mind, we recently went on a search for companies with unusually high dividend yields. After performing a quick scan for high-yield companies, we uncovered 121 stocks on U.S. exchanges that yield 7% or more. But before you get too excited, it's important to remember that stocks with the highest yield often carry the greatest risk. In fact, when we scratched beneath the surface of many of these stocks, we were struck by the truth of that old adage -- all that glitters is not gold. Take Allied Capital (ALD), for instance. Although the stock sports a mouth-watering 8.7% dividend yield ($2.28 dividend payment per share), to fund its dividend this financial services firm pays out 126% of its annual earnings. In other words, it pays shareholders more money than it makes. Meanwhile, earnings have been falling at a -6% clip each year for the last three years, plunging a whopping -26% last year. Digging deeper, we found that the firm borrows money to pay for its dividends and issues shares to buy assets to keep the business going. No matter how enticing, this high-yielder may be one temptation you may want to resist. In addition, solid dividend yields alone won't give you market-beating performance. There's no legal requirement for a stock to maintain its generous dividend payment. If and when earnings decline, corporate managers usually scale back their dividend payments and their firm's underlying share price generally deteriorates. It's important to remember that total returns include the impact of both dividend payments and capital appreciation (or depreciation). A stock may deliver a +8% yield, for example, but if its share price declines by -8% or more in a given year, then the overall return for investors will be negative. To pass muster, our high-yield winners had to meet a few hard tests: Dividend yield of at least 7%: The average yield of dividend payers in the S&P 500 is about 2%, so our high-yield picks offer cash returns of about triple the average. Steady earnings growth: Dividends are paid out of corporate earnings, so higher earnings usually translate into fatter dividend payments. Reasonable payout ratios: To avoid unsustainable dividends, we required all of our picks to pay out no more than 100% of current earnings in the form of dividends. Dividend growth: To increase the odds that a stock will deliver healthy returns over the long haul, we required a long track record of solid dividend growth. Beware the Taxman: Our winning picks come from a variety of asset types, including real estate investment trusts (REITs), royalty trusts, and master limited partnerships. These firms avoid income taxes by paying out most of their income to shareholders. Instead, shareholders pick up the tab, which means the dividends don't qualify for the reduced 15% tax rate. To take advantage of these high-yielders, investors should consider putting them in an IRA or other tax-deferred account. Below you'll find a brief description of the winning picks that survived the rigorous screening criteria noted above... SAN JUAN BASIN ROYALTY TRUST (SJT, $31.90) Overview: San Juan is a special breed of company known as a royalty trust. It exists only to pay dividends. It passes onto shareholders all the income (royalties) it receives from the oil and gas lands it holds in trust for Burlington Resources (BR).
The largest of about 30 energy-sector royalty trusts in the U.S., San Juan owns a 75% interest in 152,000 acres of natural gas lands in the San Juan basin of northwestern New Mexico. About 98% of its income comes from natural gas, with the rest from oil. As such, San Juan is a pure play on soaring natural gas prices. The catch with oil and gas royalty trusts is that once reserves are gone, so are the dividends. The company owns 4,000 natural gas wells that contain over 240 billion cubic feet of natural gas, enough for at least another 10 years of production. Dividend: Established in late 1980, San Juan has been paying monthly dividends for nearly two decades. Payments vary with natural gas production volumes and prices. The stock currently delivers an annual yield of +8.3%, based on a projected annual dividend payment of $2.57. (Yields are calculated on the next 12 months of dividend payments divided by the current share price.) Like the more widely known real estate investment trust (REIT), a royalty trust pays dividends that are taxed as ordinary income. Unlike a REIT, however, investors do not pay taxes on a portion of the royalty trust's dividends until they sell their stock. This tax deferral makes royalty trusts like San Juan a good choice for investors in high tax brackets. Performance: Despite volatile natural gas prices, the trust's earnings have grown at a healthy +25% clip each year throughout the past five years. Earnings grew a jaw-dropping +148% last year. And although they have held relatively flat so far this year, earnings are expected to jump another +30% next year based on the company's projected dividend payout. The firm's five-year earnings growth rate sits at an estimated +30%. Valuation/Outlook: The shares have soared +70% throughout the past year in tandem with record high natural gas prices. Forecasting the future of commodity prices -- and of SJT's earnings -- is more an art than a science. However, San Juan appears to have a bullish outlook. With a forward P/E of around 12X projected 2005 earnings, the stock is trading at a discount to its one-year growth rate and an even deeper discount considering the stock's +8.3% yield. Given a long-term growth rate of +30%, the stock sports a PEG ratio of considerably less than 1. (PEG compares a stock's P/E to its projected five-year growth rate. A PEG of less than 1 often indicates that a stock is undervalued.)
Although the stock's high yield provides a floor to the share price, a steep decline in natural gas prices could certainly affect both the share price and dividend payments. Royalty trusts are definitely not for the risk-averse. However, their generous dividends make them worth considering, especially with commodity prices now reaching new highs. Important Note: To view
the remainder of this article, which includes an in-depth analysis of
several additional high-yield income stocks, you'll need to read the
November issue of our premium High-Yield Investing newsletter. In each
issue editor Carla Pasternak presents her readers with three model
income stock portfolios, several in-depth articles and a host of other
investing ideas and tips designed to help you earn above-average income
from your portfolio. To receive your copy of our most recent High-Yield
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