One of the best aspects of putting your money to work in the stock market is that multiple investing strategies can be successful. Whether you prefer high-octane growth stocks or mature value stocks, a path exists to build wealth.
But among the many strategies investors have used to grow richer over time, dividend stocks might be the stand-out choice.
According to a report issued nine years ago by J.P. Morgan Asset Management, a division of money-center bank JPMorgan Chase, dividend stocks have a rich history of outperforming their non-dividend-paying peers. J.P. Morgan Asset Management compared the performance of dividend-paying stocks to non-dividend payers over 40 years (1972-2012) and found that the income stocks wiped the floor with the non-payers on an annualized basis (9.5% vs. 1.6%).
Because dividend stocks are almost always profitable, time-tested, and have transparent long-term outlooks, they’re just the type of businesses we’d expect to increase in value over the long term.
But not all dividend stocks are created equally. In fact, studies have shown that once yields hit roughly 4% (i.e., high-yield status), risk and yield tend to correlate higher. Put another way, high-yield stocks can sometimes be more trouble than they worth.
At the moment, there are two ultra-high-yield dividend stocks that investors can confidently buy hand over fist, as well as one premier dividend payer that should be avoided like the plague.
Ultra-high-yield income stock No. 1 to buy: Enterprise Products Partners (7.37% yield)
The first big-time dividend stock investors can gobble up is oil and gas play Enterprise Products Partners (EPD).
Some of you are probably looking at this suggestion with a raised eyebrow and thinking there’s no way you’d ever consider investing in an oil stock considering how rapidly crude oil demand fell off a cliff during the initial stages of the pandemic. While you’re absolutely correct in your thinking that drilling companies were hammered, Enterprise Products Partners was well protected thanks to its role as an energy middleman.
Enterprise Products Partners is a midstream provider for the energy complex. It controls in the neighborhood of 50,000 miles of transmission pipeline, has 14 billion cubic feet of natural gas storage space, and operates 20 natural gas processing facilities. The key here is that the company’s contracts are based on volume and price commitments. In other words, there’s virtually no surprises on the cash flow front, even when crude oil prices are vacillating all over the map. This cash flow transparency is important because it allows management to outlay capital for projects without adversely impacting profits or the distribution.
If you’re still worried about what happened to the oil industry during the pandemic, take a closer look at the company’s distribution coverage ratio — i.e., the amount of distributable cash flow generated compared to what’s actually disbursed to shareholders. Any figure below 1 would imply an unsustainable payout. In Enterprise Products Partners’ case, its distribution coverage ratio never fell below 1.6 during 2020.
With oil and natural gas prices now near multiyear or multidecade highs, demand for transmission and storage is only likely to grow. In short, Enterprise Products Partners is in fantastic shape and should have no trouble building on its 23-year streak of increasing its base annual payout.
Ultra-high-yield income stock No. 2 to buy: Annaly Capital Management (12.21% yield)
A second ultra-high-yield stock that’s begging to be bought is mortgage real estate investment trust (REIT) Annaly Capital Management (NLY). At 12.21%, Annaly has the highest yield of the company’s discussed on this list.
Although the products mortgage REITs buy can be a bit complex, their operating model is relatively straightforward. Mortgage REITs like Annaly seek to borrow money at very low short-term rates and use this capital to acquire higher-yielding long-term assets, such as mortgage-backed securities (MBS). The average yield from MBSs minus the average short-term borrowing rate equates to a company’s net interest margin (NIM). Generally, the bigger the NIM, the more profitable the mortgage REIT.
I’d be remiss if I didn’t point out that Annaly and its peers are facing challenging times. In particular, the interest rate yield curve is flattening — i.e., the gap between short-term and long-term Treasury bond yields has shrunk. That’s often a recipe that lowers book value and NIM for mortgage REITs.
But the important thing to note here is that yield-curve flattening is often short-lived. Historically, the yield curve spends more time steepening, which isn’t surprising given that the U.S. economy spends a disproportionate amount of time growing than it does in recession. With the Federal Reserve also set to raise interest rates multiple times in 2022, Annaly should enjoy higher yields from its MBS purchases in the coming years.
Also, take into consideration that Annaly Capital Management almost exclusively purchases agency securities. An agency asset is backed by the federal government in the event of default. While this extra protection does lower the yield on the MBSs Annaly buys, it also gives the company a path to deploy leverage to its advantage.
With Annaly averaging a roughly 10% yield over the past two decades, as well as trading 10% below its book value, now is the perfect time to buy in.
The ultra-high-yield dividend stock to avoid: Lumen Technologies (9.18% yield)
On the other end of the spectrum is telecom stock Lumen Technologies (LUMN), which I believe is best avoided like the plague.
Superficially, Lumen looks like it would pass the sniff test. The company is trading slightly below its book value, has a forward-year price-to-earnings multiple below 8, and generated $6.5 billion in operating cash flow over the trailing 12 months. But dig a bit deeper and you’ll find a number of red flags.
For instance, Lumen Technologies has primarily grown by acquisition for much of the past decade. The issue is that making acquisitions either requires a substantial amount of cash or for the acquirer to take on quite a bit of debt. In Lumen’s case, it chose the latter. Following the $25 billion buyout of Level 3 Communications in late 2017, Lumen’s debt levels soared to nearly $38 billion. Even four years after the Level 3 deal closed, Lumen’s nearly $29 billion in net debt continues to constrain its financial flexibility.
Another issue is the company’s legacy assets, which are expected to be a drag on its growth for the foreseeable future. As my Foolish colleague Adam Levine-Weinberg pointed out last month, Lumen Technologies does have a plan to return to growth, which includes selling off these slow-growing traditional telecom assets and expanding its fiber footprint. But in the interim, it means steadily declining revenue and not nearly enough investment in higher-growth initiatives thanks to its almost $29 billion in net debt.
It’s also not clear if Lumen can maintain its $1 base annual payout. Next year, Wall Street’s consensus calls for only $1.12 in earnings per share, which doesn’t leave a lot of breathing room to cover its payout. For context, the company reduced its dividend twice over the past decade.
If I wanted a high-yield dividend in the telecom space, I’d much rather own AT&T or Verizon and know that the growth needle, while moving slowly, is at least pointing upward.
Originally published on Fool.com
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.
JPMorgan Chase is an advertising partner of The Ascent, a Motley Fool company. Sean Williams owns AT&T and Annaly Capital Management. The Motley Fool recommends Enterprise Products Partners and Verizon Communications. The Motley Fool has a disclosure policy.