Monday, June 21, 2010

Highest Yielding Dividend Stocks of S&P 500

Many novice investors get in the world of dividend investing because of the belief that it is possible to generate double digit current yields. They purchase these securities in pursuit of current income, only to see these distributions cut after a few months. The truth is that few companies can afford to pay high dividends, unless they are pass-through entities such as master limited partnerships or real estate investment trusts to name a few.
I have highlighted the top 20 yielding stocks in the S&P 500 index below:

Right off the bat investors could notice that most of these issues are from the telecom, utilities and tobacco sectors. The reason why these companies yield so much is because they are sharing almost all of their profits to shareholders in the form of dividends. This is clearly unsustainable, particularly in the case of telecom carriers, which have high capital expenditure requirements in an industry with high competition. Another risk facing telecom investors is that the wireline (landline) portion of their businesses is destined to decline over the years until its extinction a few years from now. Few households have both a cell phone and a fixed line anymore, and those that still pay for both are beginning to question the benefit of the extra landline phone charges. This dying business would generate less and less in profits, which cannot be offset against cost cuts. The main bright spots for telecom providers is data and cellular phones.

Long gone are the days when telecom companies had a natural monopoly in the territories they served, which was why they were included in the list of stodgy utilities. Customers can nowadays switch carriers on a whim, once their contracts expire. Customer service is uniformly the same for the major carriers such as AT&T (T), Verizon (VZ), Sprint-Nextel (S) and T-Mobile, part of Deutsche Telecom (DT). Most customers are looking for the next “cool” phone, such as the iPhone, made by Apple (AAPL). The number of cell phone customers in the US has reached its saturation point, and most of the carriers are fighting hard for customers. Most of the additions for AT&T (T) and Verizon (VZ) seem to have been at the expense of losses at Sprint-Nextel (S). Once Sprint stops bleeding, it could potentially make it harder for competitors to take customers away.

I am generally a believer in utility stocks, since they have relatively safe cash flows and are natural monopolies in their designated areas. That being said, even when utilities cut dividends, they typically start raising them again after a few years. Utilities are subject to interest rate risk however, which would make cost of capital expensive for them at a time when investors will demand a higher yield on new stock or bond issuances.

Tobacco is also a dying business, where companies direct all of their cash flows to investors in the form of dividends and stock buybacks. The one positive for tobacco companies is that because of the ban on advertising, it is virtually impossible for new companies to enter the market. In addition to that the product is addictive, and the price increases have so far offset the declines in the number of smokers in the US. The major risk is legislation banning the use of tobacco in the US, which seems to already be priced into the shares of tobacco companies such as Altria (MO). The states need revenues, and the steep excise taxes generated by tobacco products make it very unlikely that these products would be banned in the next decade.

In general investors should not have an excessive allocation to a particular sector of the market, regardless of the high current yields. An above average allocation to high yielding sectors could lead to steep losses in current income when distributions are cut. If you purchase a $100 worth of stock yielding 8%, your expectations are for an annual dividend income of $8. If the company cuts distributions by 50% however, your dividend income would fall to $4. Many investors in financial shares suffered steep losses in income and capital after buying shares of Bank of America (BAC) or Citigroup (C ) when they had high yields.

While holding a high yielder could boost your overall portfolio yield, it is essential to create a diversified dividend portfolio representative of most sectors in the economy. This would reduce risk to the dividend income stream, and to the capital base. For ideas on companies with sustainable dividends with long histories of dividend growth check the dividend aristocrats and the dividend achievers lists.

Full Disclosure: Long MO and T

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