New income investors sometimes make the mistake of looking no further than a stock's current dividend yield. After all, a stock such as biotech firm PDL BioPharma (NASDAQ: PDL) looks mighty enticing, based on its 10% yield.
But looks can be misleading. A closer look at PDL reveals a dividend that may be in trouble. The company's net income fell by more than 50% last year, and PDL paid out more in dividends than it earned as income. The company earned $92 million, but paid $130 million in dividends.
When earnings decline sharply, even blue-chip companies can sometimes find their dividends in danger. A good example is General Electric (NYSE: GE), which was forced to trim its dividend by two-thirds during the economic downturn. Quarterly payments dropped from $0.31 to just $0.10. [See: "Forget GE, Buy These Stocks Instead"]
Another high-profile casualty of the downturn was oil refiner Valero Energy (NYSE: VLO). Valero cut its quarterly dividend from $0.15 to $0.05, which is where the dividend remains today.
So how do you protect yourself from stocks at risk of dividend cuts and identify those most able to grow dividends? A great starting point is to examine each company's payout ratio. This ratio measures a stock's annual dividend payment as a percentage of its earnings. A company that earned $1 per share in profits last year and paid a $0.60 annual dividend, for example, has a dividend payout ratio of 60%. A quick look at any free financial website like Yahoo Finance will show PDL's payout ratio at 140% -- in other words, 40% more than earnings.
In general, lower payout ratios are better. The reason for this is simple -- they leave plenty of room for dividend growth and a safety cushion if earnings decline. There are a few notable exceptions to the low payout rule. For example, real estate investment trusts (REITs) and master limited partnerships (MLPs) typically carry high payout ratios because they must, by law, pay out most of their earnings to shareholders. Apart from these special instances, however, the ideal pick for an income investor is a high-yield stock with a low payout ratio.
Finding stocks with low payout ratios is relatively simple. My initial search found more than 2,000 U.S. stocks with payout ratios for the past 12 months of 60% or less. However, the task became more complex when I added above-average dividend yield as a criterion. When I limited the search to stocks also yielding 5% or better, only 46 stocks passed the screen.
To ensure I was picking stocks that have the earnings power to support future dividend increases, I added a third metric. I restricted my list to stocks likely to deliver at least 8% earnings growth in the next 12 months.
After incorporating these three criteria into my screen, my original list of stocks was narrowed down to just five. Here is my list of high-yield payers and potential dividend growers.
1. HickoryTech Corp. (Nasdaq: HTCO)
6% Yield
58% Payout
HickoryTech provides telecommunication services to businesses and homes in the upper Midwest. The company operates a regional network that spans 2,750 route miles across a five-state area. HickoryTech delivers broadband Internet, digital TV, voice and data services. The company has a 60-year dividend history and has grown payments 3% in the past three years. The annualized dividend of $0.54 represents a 58% payout from earnings. HickoryTech recently completed an expansion of its network into the Dakotas and Iowa that analysts expect will fuel 9% earnings growth next year.
2. Kayne Anderson Energy Development Co. (NYSE: KED)
6% Yield
23% Payout
Kayne is an investment firm specializing in energy businesses and is the largest institutional investor in energy MLPs. The company currently manages $12.5 billion in assets, which includes more than $6 billion in energy MLP investments. Kayne has paid quarterly distributions since 2007. This year, the company increased the quarterly rate by 3% to $0.31 per share. Kayne's management recently said capital being redeployed after an asset sale into new MLP investments and debt securities may support quarterly distributions in a $0.33 to $0.34 range.
3. Solar Capital Ltd. (Nasdaq: SLRC)
10% Yield
51% Payout
Solar Capital is a business development company (BDC) that invests in the debt and equity of middle-market companies. The company completed its initial public offering in February 2010. By year-end, Solar held $900 million in debt securities from 30 portfolio companies and equity worth $75 million in nine companies. Solar grew its net asset value by 10% last year.
Like others in its industry, Solar benefits from tight credit markets, which make BDCs one of the few sources of financing available to small companies and makes it able to extract particularly favorable lending terms. Solar declared a first-quarter dividend of $0.60 per share. The company plans to deploy another $325 million in new capital this year. Consensus analyst estimates target 10% growth in earnings next year.
4. Sunoco Logistics Partners LP (NYSE: SXL)
5% Yield
48% Payout
Sunoco owns and operates a diversified portfolio of pipeline and terminal assets. The company operates 2,200 miles of refined product pipelines that transport gasoline, diesel and jet fuel, 5,400 miles of crude oil pipelines that gather and transport from fields in from Oklahoma and Texas and 42 terminal facilities.
Sunoco has an unusually low beta value of 0.13, which means the stock's price volatility is low when compared with the S&P 500. In the past five years, the company's quarterly dividend has increased from $0.75 in 2006 to $1.18 in 2011. Sunoco has delivered 23 consecutive dividend increases, even during 2009 when oil prices plunged. Analysts think a pipeline expansion project underway in the Marcellus Shale region will support 10% a year earnings growth for the next two years.
5. TICC Capital Corp. (Nasdaq: TICC)
9% Yield
36% Payout
TICC is a BDC that invests in information technology, Internet, semiconductor and other technology-related businesses. The company has paid distributions for 29 consecutive quarters. In this year's March quarter, TICC increased the quarterly distribution by 9% to $0.24 per share. The company grew net investment income by 79% last year. Management expects future growth to come from $130 million in new investments recently made. Consensus analyst estimates peg earnings growth for TICC at 8% next year.
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