“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 o