Cash Cows: Great Companies with 10%+ Dividend Yields

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Cash Cows
Great Companies with 10%+ Dividend Yields

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John D. Rockefeller once quipped that the only thing that gave him pleasure was to see his dividend coming in. The famous oil tycoon made that statement in the early 20th century, and for some investors during the tech boom of the late 1990s, it may well have seemed a hopelessly anachronistic sentiment.

After all, with the new millennium fast approaching in 1999, the average dividend yield on the S&P 500 had sunk to a multi-decade low below 1.2%. Meanwhile, the yield offered by the industry titans of the Dow Jones Industrial Average had sunk to just 1.6%, less than half the 3.4% rate dished out ten years earlier. At that point in time, no one seemed to care about a 1% or 2% yield when the market was rallying +15-20% annually and offering capital gains galore.

However, the frothy bull market of the 1990s was a statistical anomaly, as dividends have historically formed a key component of stock market returns over the long haul. In fact, between 1926 and 2005 the S&P 500 delivered total returns of +10.5% per year. Capital appreciation alone accounted for just +6.1% annually, or 58% of the total gains. The remaining 42% of the market's total return came in the form of dividend payments. This is a much larger percentage than most investors realize!

In part, the decline of dividends can be attributed to their high taxation, as payments were usually taxed heavily at both the corporate and personal level. However, favorable tax legislation was enacted in 2003. This effectively reduced the personal tax on dividends from as high as 38.6% (the top marginal tax bracket in 2003) to just 15%. Dividends suddenly became a much more efficient way to increase shareholder value. As a result, many companies decided to either increase their payouts or to initiate dividends for the first time, suddenly reversing a 20-year slide in the number of S&P dividend-paying firms.

In fact, according to the Cato Institute, total aggregate dividend payments shelled out by S&P 500 members jumped +18% to $172 billion in the 12 months following the new law. That staggering total has swelled in years since, coming in at $247 billion in 2007. And turning our attention to the broader markets, 1,745 companies announced dividend increases in 2004, the first full year after the change in tax legislation. Clearly, dividends are back in favor with both corporate executives and investors.

The Importance of Compounding
The dividend payments generated by a modest investment might seem to be inconsequential initially, but through the magic of compounding it won't take long before they can begin to make a dramatic impact on your portfolio.

After all, these dividends can be used to purchase more shares, leading to even larger dividend checks. These larger checks can then be used to buy even more shares and so on. In time, even a small stake in such stocks can grow into a tidy sum.

For example, suppose an investor buys 1,000 shares of stock in XYZ Corp. at a purchase price of $10 per share (for an initial investment of $10,000). Next, let's assume that XYZ pays a steady annual dividend of 10%, and the shares rise at an +8% annual rate going forward.

The very first quarterly dividend check would be worth just $250: (($10,000 * 0.1)/4). While that amount will certainly not go very far on its own, it is enough to purchase around 25 more shares at the initial $10 per share price. Of course, those 25 shares would then generate dividend payments of their own. As the chart below shows, this steady compounding process can yield amazing results over the long haul.

After 30 years, the initial 1,000 share stake in XYZ would have grown to 17,449 shares! At the same time, assuming a conservative +8% compounded annual growth rate, those shares would have soared from $10 to more than $100. As a result, the beginning $10,000 investment would have swelled to more than $1.7 million dollars, without ever adding another penny!

But what would have happened if the investor just pocketed those dividend payments year after year? Well, the stock would still be worth about $100 after 30 years, but without any reinvestment he or she would only be left with the same 1,000 shares, for a total of approximately $100,000. Even when the cumulative dividends paid of $122,346 are included, the entire investment would still only have grown to around $223,000, which is more than $1.5 million less than with dividends reinvested.

It's also worth pointing out that at the end of the 30-year period, the first portfolio would be generating annual dividend payments in excess of $170,000 ($1.7 M * 0.1). In other words, the investor's annual dividend income alone would amount to more than 17 times his or her initial $10,000 outlay!

Income Stocks Offer More than Just Solid Dividends
You might ask why should an investor bother buying high-income stocks just to earn a few extra percentage points of return when the bond market offers a safer yield? Well, the answer is deceptively simple. Stock returns are really the product of two elements: dividends and capital gains.

Both bonds and income-oriented stocks can offer attractive yields. However, unlike their fixed-income counterparts, most dividend paying securities also offer decent capital appreciation prospects over time. That means investors are able to not only earn stellar dividend yields, but they can also realize additional gains from rising share prices. Bonds simply cannot match that upside potential. Furthermore, bonds are much more susceptible to interest rate fluctuations, as rising rates can quickly erode the value of their fixed interest payments.

Income Investing is Now Back in Vogue
After more than a decade of playing second fiddle to capital gains, dividends are back in style. History shows that periods of abnormally large stock market gains are typically followed by extended periods of below-average returns. For example, the huge bull run in the Dow Industrials from the late 1940s to the mid-1960s gave way to a flat market from 1965 to 1980. Over this period, the Dow actually returned less than +1% annually (excluding dividends). This same pattern held true after the 1920s bull run and was also seen in the Japanese Nikkei after its huge advance during the 1980s. After the big run-up we've seen in the past few years, and the subsequent subprime crisis and general economic uncertainty afterwards, we could in for an extended period of uninspiring trading action.

One effective way to make money in a flat (or even declining) market is to collect dividends. In the slow growth decade of the 1970s, dividends accounted for nearly 80% of the market's total returns (as opposed to 10% during the 1990s). This strategy holds true because companies that pay dividends tend to have more reliable, stable businesses that hold up better during challenging economic conditions.
After all, to pay dividends over a prolonged period of time, a company must be able to generate dependable earnings. These are exactly the sort of companies that investors turn to for shelter in troubled times.

Each of the securities we'll profile in today's report features yields of 10% or higher -- that is far better than the rates offered by competing money market accounts, CDs, government bonds, or any other typical income securities.

TABLE OF CONTENTS:

1. What to Look for in a Solid Dividend-Paying Security
2. Frontline (NYSE: FRO)
3. Macquarie/First Trust Global Infrastructure (NYSE: MFD)
4. Capstead Mortgage Preferred B (NYSE: CMO-PB)
5. B&G Foods (NYSE: BGF)
6. Invest Like the Legends

(1.) What to Look for in a Solid Dividend-Paying Security

While it might be tempting to invest exclusively in the market's highest-yielding securities, this shortcut approach usually leads to mediocre returns. To begin, off-the-charts dividend yields are typically the result of very depressed share prices. In many cases, the companies that offer such high yields are in poor financial shape.

In addition, poorly performing companies often see their share prices decline even further, leading to dismal overall returns. Remember that income stocks offer returns from two sources: dividends and capital gains (or losses). With this in mind, although you can hold a stock that offers an exceptional 15% dividend yield, if the underlying shares lose -20%, then your investment will end up losing money.

Furthermore, most dividends are by no means guaranteed. Companies can reduce their dividend payouts (or eliminate them altogether) whenever they like. As such, a fat dividend yield alone does not guarantee investment success.

With this in mind, we prefer to focus our research on those securities with a proven ability to not only pay dividends year after year, but also to increase their payouts. We also examine a number of other factors to ensure that our investment ideas are fundamentally sound, and look for securities with the best total return potential.

In an effort to determine whether a particular firm can be counted on to pay a sizable dividend plus deliver steady capital appreciation in the coming years, we've established a list of important investing criteria. Before investing in any dividend-paying stock, we carefully evaluate each of the following fundamental factors:

Yield -- A dividend yield indicates the annual return that a security delivers in the form of dividend payments. The yield can be calculated by simply dividing the annual dividend payment per share by the security's current stock price. For instance, let's assume XYZ Corp. is currently offering quarterly dividend payments of $0.50 per share for a total annual distribution of $2.00. Let's also assume XYZ stock is currently trading at a price of $50 per share. In this case, Company XYZ offers an annual dividend yield of 4% ($2.00/$50.00). In an effort to hone in on companies with the most impressive dividend yields, today's report focuses exclusively on securities with yields of 10% or more.

Payout Ratio -- Although we want to earn high returns on our investments, we're also careful to watch for too much of a good thing. A company's dividend payout ratio indicates the percentage of a firm's earnings that management is paying out to shareholders. The payout ratio can be calculated by dividing a stock's annual dividend payment by its annual earnings per share.

The average payout ratio for a component of the S&P 500 Index is around 30%. However, this figure varies greatly from industry to industry. Many high-tech sectors, for example, retain nearly all of their earnings to deploy back in the business. They therefore have very low (or zero) payout ratios. On the other hand, mature, slower-growing industries, such as utilities or banks, often boast payout ratios as high as 70% or more.

Meanwhile, real estate investment trusts (REITs) maintain even larger payout ratios, as they are required by law to return 90% of their earnings to shareholders in the form of dividends. And finally, some companies pay out more than 100% of their earnings to shareholders. In general, we prefer to avoid such firms, as those types of payout ratios almost always prove unsustainable over the long haul.

As a rule of thumb, we generally look for securities with dividend payout ratios below 80%. However, there are certain exceptions to this rule. For example, the payout ratios of securities such as master limited partnerships, Canadian income trusts and shipping firms can seem deceptively high if they are based on earnings instead of available cash flow. That's because these companies typically have very high non-cash depreciation expenses, which reduce earnings but don't affect the cash flow available to shareholders.

Reliability -- Companies are under no legal obligation to continue paying dividends. Therefore, we want to find those that we can count on to maintain and hopefully even increase their quarterly dividend payments. We usually look for companies that have paid consistent dividends for several years. Also, we look for firms with strong track records of increasing those dividend payments. A lengthy history of stable (or rising) dividend payments is often convincing evidence of a company's commitment to its shareholders.

Total Return -- Although dividends are certainly an important part of the picture, they don't represent the whole story. In the end, the total return that a stock delivers is a combination of its dividend yield and capital appreciation. A stock may pay a decent annual dividend, but if its share price declines year after year, then the net effect could be a flat, or possibly even a money-losing investment. Although income investors are typically willing to trade capital gains for the relative safety of predictable income, we prefer to look for stocks that offer the best of both worlds -- rich dividend payments and solid long-term growth potential.

Taxes -- Income investors should always be mindful of the after-tax rate of return they earn on any investment. A stock may pay a solid dividend, and its shares may outperform the market, but if those gains are taxed at a stiff rate, then this may neutralize them. As mentioned earlier, several years ago the tax rate imposed on most dividend distributions was reduced to 15%. One notable exception, however, are real estate investment trusts (REITs). Their distributions are still taxed as ordinary income at rates as high as 35%.

On the other hand, despite the higher tax rate, many REITs still generate after-tax returns that are far superior to other income stocks. Therefore, investors may want to consider shielding REIT dividends and other unqualified dividends by placing those stocks in qualified, tax-advantaged accounts, such as IRAs.

With all this in mind, our research staff thoroughly analyzed the universe of securities with 10%+ yields. We'll devote the remainder of this report to a closer look at their favorite double-digit yielding investment ideas.

(2.) Frontline (NYSE: FRO)

Snapshot: Frontline leases crude oil transport ships to companies all over the world. The company owns and charters a fleet of 20 mid-sized Suezmax carriers, which are designed for shorter journeys, and 42 Very Large Crude Carriers (VLCC), which are used to transport crude over long distances. The company also charters eight oil/bulk/ore (OBO) carriers.

Like most tanker firms, FRO leases its ships under a combination of spot and time charter contracts. Time charter contracts are longer-term contracts at a fixed day rate -- often charters can be one to five years in duration. Spot rates are short-term agreements cut at the prevailing market day rate at the time of contracting. Spot contracts offer more upside potential. Meanwhile, time charters offer more stable, predictable rates. The advantage of FRO's balanced contract portfolio is that its spot rate contracts allow it to benefit handsomely during strong tanker markets, while its time charters offer a measure of stability during weak periods.

Frontline (NYSE: FRO)

Business: Leasing crude oil carriers with both spot and time charter contracts
Annual Payment: $8.25
Yield: 28.5%
Frequency: Quarterly

Tanker rates are determined by two main factors: the supply of tankers and demand for crude oil shipping. Demand for shipping has been growing rapidly in recent years as countries like China and India import greater quantities of oil. It is estimated that the United States is responsible for one quarter of annual oil consumption worldwide. China only uses one-third of what the U.S. uses, but it is expected to be consuming at present day U.S. levels in the next few decades. Of course, this means more oil imports, which increases demand for Frontline's tankers.

On the supply front, although new tankers are being built, this new supply is being partly offset by the phase-out of older, single-hull tankers. Single-hull tankers are more prone to spills, and thanks to recent international agreements, all single-hull ships will be phased out over the next few years. Many major energy producers have already decided to lease only double-hull ships -- well ahead of international deadlines. This bodes well for Frontline, whose fleet is already made up mostly of double-hulled tankers.

Dividends: As a fallout of the credit crisis, Frontline temporarily lowered its dividend in December 2008 as a means to preserve capital. Even so, based on the total trailing twelve month dividends of $8.25 per share, the stock carries a yield of roughly 28.5%, making it a compelling choice for aggressive-minded income investors. With shipping rates at current levels, FRO is cash flow positive on the operating side. And as rates continue to strengthen, FRO's cash flow generation allows FRO to pay its impressive dividends. As long as demand for crude remains high and the supply of transport vessels low, this firm should benefit and continue offering an attractive dividend.

Outlook: While tanker rates are volatile and seasonal, strong long-term demand should spell a rebound in rates. And with the continuing phase-out of single-hulled tankers and sustained demand for energy from emerging markets, these rates look to increase further -- benefiting Frontline for years to come. Furthermore, FRO carries a forward P/E ratio of under 12, making its valuation attractive as well.

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(3.) Macquarie/First Trust Global Infrastructure/Utilities Dividend & Income Fund (NYSE: MFD)

Snapshot: This closed-end fund focuses on dividend-paying stocks based both in the U.S. and overseas. A majority of the fund's holdings are involved in the utility industry, including stocks and bonds of companies providing electricity, water, and wastewater services. The fund is also heavy in natural gas and oil pipeline plays -- another sector that tends to offer high yields for investors.

MFD's portfolio typically consists of about 70% stocks and 30% corporate bonds. In addition, the fund holds a majority of its portfolio in international securities.

The utility stocks MFD invests in are stable income-paying securities. Demand for basic services such as electricity and water is steady and predictable. After all, there's a reason the utility industry is often called the "essential services" industry -- because most consumers can't live without these utilities, demand remains steady throughout good times and bad.

Macquarie Infra./Util. Fund (NYSE: MFD)

Business: Invests in utility and infrastructure securities around the world
Annual Payment: $1.70
Yield: 18.0%
Frequency: Quarterly

And because they often operate as monopolies, the utility industry is heavily regulated by the government both in the U.S. and overseas. In most cases, the government sets the rates utility companies can charge their customers. These rates are designed to enable the utilities to earn a fair rate of return on their assets without allowing them to abuse their position in the market.

The end result of strong demand for utility services coupled with government regulated prices is a highly defensive sector with slow growth but strong, steady cash flows. Better still, those predictable cash flows are what enable the best-run utilities to pay consistent dividends to their shareholders.

Dividends: Over the past four quarters, the fund has paid out $1.70 per share in regular dividends, giving it a handsome yield of 18%. Meanwhile, the regular quarterly dividend has surged a remarkable +42% since MFD first launched in 2004 to its current $0.425 per share. Driven in no small part by its growing dividend, MFD has produced average annual returns of more than +16% in its first four full years of operation.

Outlook: With major holdings like Italy's largest electric and natural gas utility firm, Enel, as well as British water and power utility giant United Utilities, MFD holds a strong portfolio of securities with consistent cash flows. That should enable investors in the fund to see steadily growing dividends and consistent share price appreciation in the coming years.

(4.) Capstead Mortgage Preferred B (NYSE: CMO-PB)

Snapshot: As you may be able to tell by the hyphenated CMO-PB ticker symbol, this particular selection represents the preferred shares of Capstead Mortgage (NYSE: CMO), a real estate investment trust (REIT) that invests primarily in pools of mortgage loans. When investing in mortgage REITs, the biggest dividend payouts with the lowest risk are typically not found in common stocks, but in preferred shares. Preferred shares trade daily on stock exchanges just like common stock, but they also have the fixed income characteristics of a bond.

The good news for investors is that CMO-PB is one of the most attractive of the bunch. Despite recent turmoil in the subprime mortgage market, Capstead Mortgage has remained remarkably resilient.

That's because this Dallas-based REIT invests mainly in single-family, adjustable rate mortgages (ARMs) issued and guaranteed by government-sponsored agencies like Fannie Mae (NYSE: FNM) and Ginnie Mae. These so-called "agency" securities carry an implied "AAA" rating, meaning they carry virtually no credit risk.

Capstead Mortgage Pref. B (NYSE: CMO-PB)

Business: Invests primarily in single-family adjustable rate mortgages issued by large lenders such as Fannie Mae
Annual Payment: $1.44
Yield: 10.0%
Frequency: Quarterly

Any concerns investors had with Capstead's holdings evaporated when Treasury Secretary Henry Paulson announced the government was taking over mortgage giants Freddie Mac and Fannie Mae.

Now, Fannie and Freddie are in a federal conservatorship. The two entities are doing business and have access to capital from Uncle Sam's coffers and the backing of the federal government. So-called "agency" debt like Fannie and Freddie has always been highly rated, but Paulson's intervention calmed everyone's fears.

As a result, the securities Capstead invests in now have the explicit backing of the federal government. This is obviously good news for CMO-PB investors as it means the underlying portfolio is as secure as possible.

Dividends: Over the last five years, shareholders have received steady monthly dividends of $0.105 per share. Even without the impact of capital appreciation, the shares' 10% dividend might be enough to top the performance of the major averages over the next few years.

For investors seeking both dividends and capital gains, this particular preferred stock may be what they are looking for. While most preferred shares tend to trade in a relatively stable range (compared to the common shares) and have limited upside potential, CMO-PB is a convertible preferred. This means investors have the option of converting their preferred shares into Capstead's common stock. Therefore, shareholders are free to keep collecting the dividend checks as long as they choose, but also have the privilege of participating in the upside capital appreciation potential of the underlying common stock.

Based on the conversion ratio of approximately 0.6 common shares for each preferred share, few would choose to convert their shares at current prices. However, this attractive feature provides added flexibility and a potential opportunity to cash in on a sharp advance in Capstead's common stock.

Going forward, there are reasons to believe that Capstead's shares could increase in value. In late 2007 the company offered an additional 8 million common shares for sale on the open market. This offering netted more than $80 million for the firm, which it plans to use to buy more mortgages -- which should strengthen the company's future earnings.

Outlook: Capstead is well-managed and has a successful track record of managing a leveraged portfolio of real estate securities, as well as modest real estate holdings. In fact, while much of the industry languished in 2008, Capstead's net income increased by more than +1,000%. And with most of its assets tied to adjustable rate mortgages (backed by government-sponsored agencies), the firm is somewhat protected from interest rate fluctuations. Looking forward, the firm's core portfolio is well positioned to weather the storm in the subprime mortgage sector.

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(5.) B&G Foods (NYSE: BGF)

Snapshot: The maker of B&G pickles, Ortega tacos and sauces, and Grandma's Molasses, B&G Foods sells condiments and spices to grocery chains and food service outlets. Wal-Mart is its biggest customer and celebrity chef Emeril Lagasse's line of seasonings is its top-selling brand. The snack food maker has manufacturing plants across the U.S., and sells its products throughout North America. Formed in 1996, BGF went public in October 2004 as an income deposit security.

Dividend: BGF had delivered dividends of $0.427 per share from 2005 until the 3rd quarter of 2008. In October 2008, BGF reduced its quarterly distribution to $0.385 The new dividend rate, while still paying out the greater majority of its excess cash to stockholders, provides a portion of excess cash to be retained for working capital, and acquisitions.

The new dividend rate gives the security an annual payout of $1.54 and a yield of 14.0%.

B&G Foods (NYSE: BGF)

Business: This food maker owns such popular labels as Ortega, Las Palmas, B&G, Emeril, and Accent, among others
Annual Payment: $1.54
Yield: 14.0%
Frequency: Quarterly

The firm's total cash payments consist of $0.68 in common share dividends and $0.86 in interest income from a bond yielding 12%. In 2007, over 90% of BGF's dividend was treated as a return of capital and was therefore taxed by reducing the investor's cost basis when they sold the shares. As usual, the bond interest is taxed as ordinary income, making the shares suitable for tax-advantaged accounts.

Outlook: Thanks to a series of acquisitions, B&G has grown since its start in 1996 from about $100 million in sales to roughly $450 million. It has made several acquisitions over the years, including the February 2007 purchase of Cream of Wheat and Cream of Rice from Kraft for $200 million.

Brand recognition is the name of the game in the food industry. B&G Foods has done an excellent job of leveraging the success of its top brands by developing a bevy of products under such popular labels as Emeril, Ortega, and Polaner. Since acquiring the Polaner line of preserves in 1999, B&G has transformed it into North America's leading brand of low-calorie fruit preserves. It has captured nearly a 50% share of the sugar-free preserve market by targeting the rapidly growing diabetic population and appealing to widespread concerns about obesity and nutrition.

Like other food makers, B&G was challenged by rising food and packaging costs due to rising commodity costs. And currency prices are impacting the bottom line too. Profit margins on its popular maple syrup brand had been hurt by the appreciation of the Canadian dollar versus the U.S. dollar. But some of these commodity price pressures appear to be subsiding.

In an effort to improve profit margins, the company has started shuttering low-margin production facilities. In 2005, for instance, it closed its large Trappey's hot sauce plant in Louisiana. BGF has also begun to raise prices and has taken steps to reduce its workforce by 7.5%.

B&G has put together an attractive portfolio of popular food brands that have been around for years and are well-recognized by consumers. Acquiring new labels will continue to be an important part of management's growth strategy. However, even more important to the company's long-term success is its ability to adapt its products and packaging to ever-evolving consumer tastes.

Margin pressures are a headwind, but the steps the company is taking to raise prices and cut costs should continue to boost the bottom line. BGF's dividend reduction improved the long-term sustainability of its distribution, which is also aided by the substantial dividend safety built into the income deposit security share structure. Given the improved security of the dividend, as well as the firm's positive outlook, BGF could make an excellent addition to a well-diversified income portfolio.

(7.) Conclusion

While many investors are drawn to the prospect of earning quick profits, true investing success is seldom found overnight. Legendary investors like Warren Buffett and Peter Lynch have proven that the path to wealth lies in thorough research and a long-term perspective. There are no shortcuts.

So, how did these legends beat the market over time? They did so by capturing steady, consistent gains, year in and year out. Investing for the long haul is really nothing more than a game of compounding by earning a consistent return and reinvesting your profits back in the market over and over again. And of course, the magic of compounding is most powerful when an investor focuses on established companies that throw off a steady stream of dividends.

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Thank you for reading this special report: Cash Cows.

Editorial Staff
StreetAuthority LLC
839-K Quince Orchard Blvd.
Gaithersburg, MD 20878-1614

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