“Favorite High-Yield Stocks for 2011” part one

Sniffing out picks from the Dick Davis Dividend Digest

By Travis Johnson, Stock Gumshoe, February 17, 2011

I haven’t sniffed out much in the way of dividend-paying stocks or income strategies in recent weeks, so this latest teaser from the folks at Cabot caught my eye. It’s not really a tease for Cabot picks, but for the digested picks of the Dick Davis folks (Dick Davis Digest is a regular digest of newsletter picks from a variety of publishers, but it’s now published and owned by Cabot). The Dick Davis universe is now split, with the Dick Davis Investment Digest being the traditional stock-pickers abstracts, and the Dick Davis Dividend Digest being the excerpts of income-focused picks.

And this week I got a few questions about a teaser ad for the Dividend Digest, which throws out hints about a few of the picks that made the digest’s special report called The Top 29 Cash Cows for 2011.

I don’t know what all 29 are, but I can at least try to identify the favorites that are hinted at in the ad. And I know that a lot of my readers are income-focused (and I have no objection to getting a nice fat dividend, if I’m being honest with you), so maybe there will be something interesting in the pile. Let’s get started, shall we? Each set of clues also identifies which newsletter supplied the pick, though I hadn’t heard of a couple of these:

“This mortgage REIT sailed through the financial meltdown, while Countrywide, Washington Mutual, and dozens of other big players in the mortgage business crashed and burned. And it paid a fabulous dividend throughout, now standing at 14%. Neil Macneale, 2 for 1 stock Split Newsletter.

There are a solid half-dozen or so mortgage REITs that have been around for more than a couple years and could therefore claim to have “sailed through” the financial meltdown. And of that list, there are two of the relatively major players that yield roughly 14% right now — Annaly (NLY) and Hatteras (HTS). The yields on almost all mortgage REITs are very large, though some that are perceived as less risky or more sustainable are down below 10%, like Redwood Trust (RWT) or MFA Financial (MFA), and some that are seen as chancier (for example, they might hold something other than government-secured mortgages, like commercial or private mortgages, though there are other risk factors as well) have yields that approach 20%, like American Capital Agency (AGNC) or Chimera (CIM).

Annaly has been covered many times in this space — it is by far the largest player, and very well respected in the sector, and the management team has proven that they can manage at least relatively well through changing interest rate environments. What mortgage REITs effectively do is raise equity capital (sell stock), then leverage that with short term debt up to maybe 8 or 10X in some cases, and use that expanded asset base to buy mortgages (in most cases, they buy only government-guaranteed mortgages, processed by the likes of Fannie Mae). Or in investor terms, they borrow short and lend long — so as long as they can manage the risks of their mortgage portfolio (including interest rate adjustments and prepayments), they can essentially pocket the difference between the mortgage income they get and the short-term interest they have to pay on the money they’ve borrowed. That difference is often in the neighborhood of 1.5-2.5% these days, so you get the huge returns of 12-20% because you’re leveraging up that difference with borrowed money.

So you can probably see the risks — the major headache for their business model is a change in the yield curve, if 10-year rates got much closer to 1-year rates, they’d have much less opportunity to make money, so to different degrees the management teams of these REITs try to plan for and hedge the impact of interest rate changes. Whether or not you’re interested in one of these specific names, Annaly probably has the best website for doing some research on the basics of the industry, including very helpful regular commentaries on the mortgage market.

And it’s worth noting that although Annaly has also had two big downdrafts in the last several years, largely from the inverted interest rate curve of 2005 and the financial crisis of 2008, but if you avoided buying at the highest levels, in the $20 range (I don’t know how you would have, but if you did), it would have certainly been a great hold for the past decade despite the fact that the dividend has almost always been well above 10% and therefore a fairly high perceived risk.

I know a great many of my readers have invested in NLY and their competitors over the years, so perhaps some of them will share their updated thoughts with a comment below — the stock, like most of their competitors, has been quite steady of late, holding right around the $18 level since last Spring. In the end, it’s about big picture interest-rate changes, any wholesale changes you see coming for the mortgage market (short rates going up is bad because it increases their borrowing costs, especially if short rates go up but mortgage rates stay the same. Long rates going down is generally bad, not only because their income drops as the difference between short and long rates shrinks but because lots of folks refinance and prepay their old mortgages — but if they go up too sharply that’s bad, too, because their portfolio loses value compared to new mortgages). I’ve been tempted by both NLY and HTS over the past year or two but, other than a bit of speculating in their options, have not owned them, and I currently have nothing invested in any of the mortgage REITs. Do keep in mind that if you like the prospects for these businesses, high-yield mortgage REITs can be great assets to hold in tax-advantaged accounts — high distributions that can compound without a tax bite.

Well … I blathered on about that one for longer than I intended. Let me get into one other of the teased stocks, and then I’ll try to follow up next week on a couple others.

“This integrated media company broadcasts in 30 languages to 145 countries, providing television, live events and pay-per-view specials. It also licenses more than 200 consumer products and has partnerships with Walmart, Target, GameStop and Toys ‘R’ Us. If next year’s earnings come in as estimated, we’re looking at a 12-18 month gain of 50% on this one. Add in the 10.3% dividend and it’s a 60%-plus total returner. Eric Dany, Stock Prospector.”

Sounds exciting, right? Like Viacom or Time Warner or Disney or something? Nope, this is something a bit more niche-y, this tease is for …

WWE, Inc — better known as World Wrestling Entertainment and previously known as the World Wrestling Federation, and home of Wrestlemania (ticker WWE)

And yes, it is always surprising to me what a big multimedia company WWE has become — professional wrestling is arguably less of a hit than it was ten or 20 years ago, but it is certainly a more efficiently run business, and an increasingly global one. They’ve even been producing more Hollywood movies, some of them successful, and they continue to churn out a nice profit.

The company is designed to pay out a huge dividend, and in fact it pays out a dividend right now that is probably unsustainably high unless their revenue growth picks up in the near future — the shares are also down sharply from their highs of last Spring, with the most recent bad news being lowered guidance by the company for last quarter, followed by the actual just-as-bad-as-expected results that formally came out about a week ago.

It’s not surprising that WWE has been a favorite of dividend aficionados for years now, that’s what happens when a stock pays out most of it’s cash flow and carries a near-double-digit yield, but when your stock appeals primarily to dividend investors, it’s wise to be prepared to see it sell of sharply if there’s any hint of a dividend cut — so that’s what happened over the past couple months. So far the company says that they’ll continue the high dividend, which does equal a yield of about 12% still, but also that they’ll re-evaluate every quarter.

WWE is depending on foreign markets for growth — particularly Mexico, China, Turkey, Brazil, and Russia — many of which are places that have a strong wrestling tradition (not that this is “real” wrestling, but perhaps there’s some innate appeal). According to this take by a Motley Fool writer following the last earnings, one of the real disappointments in the quarter was weak international growth. They haven’t generated enough cash to cover the dividend for the last couple quarters, though they did generally do so before that (earnings haven’t ever covered the dividend in recent history, but cash flow has — in the last few quarters they’ve been cutting costs but have still had to use their cash hoard to keep the dividend up).

The stock has usually traded at a bit of a premium to the S&P average, though it’s hard to really identify peers that can tell us anything, and it does still trade at a slight premium based on PE ratios. I find it amazing that they have built such a substantial business on pro wrestling personalities, even bringing back Dwayne Johnson (The Rock) from Hollywood for some “performances” lately — they make their money by turning these performers into stars, getting fans involved enough to pay for live performances or pay per view events, licensing their performers and name for toys, video games and other doodads, and giving their performers a lifeline to post-wrestling stardom by producing relatively low-budget family movies (WWE in general remembers that their strongest market is kids and adolescents, they keep everything “PG”).

The competition becomes more challenging every day, I’m sure — not just because there are other non-WWE wrestling events, but because there are so many demands for entertainment time and dollars. Since I haven’t paid much attention to pro wrestling since Andre the Giant and I have a hard time believing that wrestling is still a profitable business and a hit, I’m probably not the best person to judge whether they’ll be able to get their growth re-started, particularly overseas, and cover that juicy dividend in the years to come. They are still creating stars, and still trying to build the brand and still trying to innovate — even possibly introducing a WWE TV network at some point … and who knows, now that Linda McMahon (wife of founder and CEO Vince McMahon) has had her political aspirations shelved (she lost in the Connecticut Senate race), maybe the McMahon focus will bring them back to the strong performance they’ve sometimes shown in past years.

So there you have it — two dividend ideas from two different folks, courtesy of the hints dropped by the Dick Davis Dividend Digest. There are a few more that look interesting too, so I’ll try to get to them soon for you. In the meantime, if you’ve got a thought on mortgage REITs or professional wrestling, well, feel free to toss it on the pile with a comment below.

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