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Long/short equity, bonds, hedge fund manager, investment advisor
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Investing towards retirement traditionally has two main features:

1. Reducing the level of risk over time so when you reach retirement the amount that has been gathered along the years would be (relatively) safe mode.

2. Increasing the allocation to income-generating instruments as time goes by.

For many investors this philosophy mean that over time their portfolios contain more bonds at the expense of less risky equities. While I don't argue with that process - as a matter of fact I'm a bigger fan of bonds over equities myself - I believe that there should be no reason whatsoever to combine the two. At an early stage, i.e. many years before retirement, one may enjoy the best of both worlds: high yield on one hand, and potential for capital gain on the other hand. Adding to this relative safety and you get yourself into a win-win situation that any investor should find hard to resist.

In this article I'd like to recommend on four stocks that I refer to as my "A-Team": KFN, BKCC, NMM, MMLP. These four stocks offer high dividend yield on one hand but relative safety on the other hand. When I'm saying "relative safety" I don't mean "risk-free"! High yield doesn't come without a risk. The "relative safety" refers to the safety of the dividend yield and payout ratio of these stocks in the foreseeable future. The many valuable features of these four companies, combined with their healthy balance sheets, create an attractive risk/reward profile.

Investing towards retirement was pretty static for many years until the 21st century began. Then, suddenly, years of savings suffered few major hits: The burst of the Internet bubble in 2000, September 11, 2001 and the financial crisis of 2008-2009 that keeps carrying out unpleasant "follow ups" every now and then, e.g. Italy. In such an environment and when equity markets may pull back substantially over a short period of time due to a major shock, it's extremely important to pick instruments that are not only paying handsomely but also (relatively) safely.

Many investors used to perceive Mortgage REITs ("mREITs") as a "high yielding safe haven" and for a couple of years they indeed were. Nevertheless, the monetary policies that followed the 2008-2009 crisis, especially QE3, have changed the old perceptions and mREITs are now competing in a new, very challenging, ball game.

During most of 2012 mREITs have suffered substantially. Regardless of their type - an agency, a non-agency or a hybrid (=a combination of both) they've seen their dividend yields and/or stock prices declining quite sharply.

The main reason behind these declines was the Federal Reserve's QE ongoing policy. The latest QE3 was the one that caused the most damage because it caused mortgage rates to go down and consequently encouraged homeowners to refinance, i.e. replace their old, high-rate, mortgages with new ones that are bearing lower rates. As a direct result, the portfolios held by mREITs were shifting and adjusted to lower rates. For mREITs, portfolios that are generating lower rates/yields mean smaller profit margins and smaller net income.

Over the last couple of years mREITs paid some very high dividend yields to their shareholders. Yields in the 15%-20% weren't that rare. Suddenly, the days of high earnings that justified these levels of dividends were gone. It was the end of an era. Most of the mREITs had to cut their dividend yields or will have to do so soon. The high double-digit yields came down to earth and mREITs lost their status as "income haven". Furthermore, as a result of the dividend cuts, the stock prices of many mREITs plunged and the share prices had to adjust to the new era of lower earnings and lower payouts.

Companies like Annaly Capital (NYSE:NLY), American Capital (NASDAQ:AGNC), CreXus Investments (NYSE:CXS), Chimera (NYSE:CIM), Armour Residential (NYSE:ARR), Invesco Capital Mortgage (NYSE:IVR), Two Harbors (NYSE:TWO), New York Mortgage Trust (NASDAQ:NYMT), Dynex Capital (NYSE:DX), Anworth Mortgage Asset Corp (NYSE:ANH), Hatteras Financial (NYSE:HTS), CYS Investments (NYSE:CYS), and Apollo Residential (NYSE:AMTG) are examples for stocks/mREITs that had already cut their dividend payout or are expected to do so soon.

Although it seems like mREITs share prices stabilized since the beginning of 2013, I've been negative on mortgage mREITs for a while, and I believe that the dividends on agency mREITs are almost certain to be cut further. It is most probably not the right time to move back to mREITs, not only due to more dividends cuts that are expected going forward but also because of QE. As long as the Fed keep on pumping money the risk/reward profile of mREITs seem somewhat doubtful.

While mREITs lost their "high yielding safe haven" status and for those looking to stick with income-generating stocks I'd like to propose what I call my "A-team" - stocks that one can count on to keep on delivering high yield and more importantly: attractive risk/reward profile. Again, by saying "attractive" I do NOT mean risk-free. Not at all! ANY stock which pays a high dividend usually has some sort of risk, otherwise it wouldn't pay that high of a dividend, would it?... As far as I am concerned, the "trick" is to identify those stocks that you can count on, with relatively high probability, to maintain their dividend yield as well as to be managed in a way that would not lead into unpleasant surprises that would lead to a sharp dividend cut.

My" A-Team" of high yielding stocks is comprised of four stocks that have quite a lot in common. As I just mentioned above, more than the dividend itself, it's important to make sure that the companies you count on for a steady stream of income are led by a great management that will carry out a well-defined strategy in the most possible solid form. This may sound easy. Well, mREITs proved that it ain't necessarily so.

My "A-Team" components and their 10 common features

The four stocks that are part of my "A-Team" are:

  1. KKR Financial Holdings LLC
  2. BlackRock Kelso Capital
  3. Navios Maritime Partners L.P.
  4. Martin Midstream Partners L.P.

These stocks have a lot in common. Not because of their lines of businesses but based on their qualitative features. Some of those features may seem more quantitative than qualitative but, for example, when I'm looking at revenues or growth - it's not the number itself that is of interest but the continuation-ongoing trend along the years. I'm following a list of 10 such features and when I'm evaluating an income play, suitable even for a retirement account, I'm checking first and foremost those features, not instead but even before I check the books, accounting methods, cash flows and financial ratios. As a matter of fact, in order to "apply" for my "A-Team" a stock needs to comply with at least nine out of the following characteristics. It's therefore no wonder that a stock that makes it into the A-Team doesn't need to "show off" more than the following features already do:

  • Great management (leading and not being led) and leadership (planning ahead)
  • A well run and focused business
  • Clear strategy that is well-defined and easy to stick to
  • High dividend yield...but not too high; over 15% usually seems unsustainable to me
  • Steady stream of income; no "sudden" fluctuations in payouts
  • A business which is relatively easy to understand and solid enough to be suitable (even) for a retirement account
  • Solid financial results, revenue growth; without too much "noise" or fluctuations along the years
  • Continuous history of dividend payouts, without extreme jumps or drops
  • Consistent earnings growth that isn't based on one-off items or one time events
  • Insiders buying and/or high institutional holdings (strong and reliable shareholders)

Once a stock is crossing these 10 features I'm checking more data, numbers and ratios but it's safe to say that as soon as it crosses this ultimate test - the rest is usually trivial.

Additional-specific features of the "A-Team" On top of the "10-features test" each of the four stocks in my A-team has additional-specific characteristics that make it even more attractive. Here they are:

1. KKR Financial Holdings LLC

52wk high: 11.93

52wk low: 7.95

EPS: 1.88

P/E: 5.90

Div Rate: 0.84

Yield: 7.6156

Market Cap: 1.99 B

Additional-specific features:

  • well-diversified portfolio
  • specialty finance company that invests in a wide range of asset classes with the goal of generating both current income and capital appreciation
  • generates revenues and profits by collecting dividend and interest income from investments and realizing gains from the sale of assets
  • attractive dividend yield
  • stable price history
  • stock price is trending up
  • insiders buying
  • potential for capital gain
  • based on price to book value, KFN is trading at almost no premium and is not trading anywhere close to its historic high valuation
  • an LLC; treated as a partnership for tax purposes
  • distributions per unit have gone up from 42 cents (2010), through 67 cents (2011), to 86 cents in 2012
  • the payout ratio is very reasonable - below 50% - thus sustainable
  • over 60% institutional ownership of all outstanding shares
  • tremendous growth in both revenues and earnings
  • high operating margins

My target price: 16

2. BlackRock Kelso Capital

52wk high: 10.82

52wk low: 8.99

EPS: 0.85

P/E: 12.10

Div Rate: 1.04

Yield: 10.0483

Market Cap: 773.03 M

Additional-specific features:

  • offers investors the potential for the best of both worlds: income and capital appreciation
  • a combination of BlackRock and Kohlberg, Kravis, Roberts management teams - a combination which is highly regarded
  • great dividend yield
  • high Income, perfect for retirement
  • a well-diversified portfolio
  • high payout ratio which is quite reasonable for a BDC (business development company) since they, like mREITs, must pay out at least 90% of their income as regular dividends to shareholders
  • low price to book value with almost no premium
  • over 50% of outstanding shares held by institutions
  • simple business model: lending money to (many) businesses that otherwise (most probably) won't be able to obtain a loan from a bank
  • as a BDC, BKCC receives a higher rate of return from the businesses they lend money to
  • potential for capital gains out of stakes they sometimes take in companies they lend money to
  • solid YoY revenue and earnings growth
  • high operating margins

My target price (for those not wishing to enjoy the income stream): 13

3. Navios Maritime Partners L.P.

52wk high: 16.83

52wk low: 11.53

EPS: 1.46

P/E: 9.20

Div Rate: 1.77

Yield: 13.0917

Market Cap: 824.24 M

Additional-specific features:

  • an international owner and operator of drybulk carriers with long-term contracts
  • consistent double-digit dividend payments for the last four years
  • the dividends have been on a rise
  • the company's fleet is on long-term charters that assist in avoiding the volatility that surrounds the shipping industry
  • a relatively high visibility of both earnings and dividends
  • high charter coverage
  • continuous growth - adding new vessels
  • less leveraged than the average norm in the industry
  • insulated from the European debt crisis and guaranteed to sell the vast majority of its products
  • strong market presence in Europe, Asia, North America and South America
  • positive trends in all key metrics: revenues, net income and cash flow
  • strong balance sheet
  • conservative management with a well-defined strategy
  • as a master limited partnership (MLP) it's structured for tax advantages; treated as a "C Corporation" for US tax purposes, i.e. a standard 1099-DIV and tax free dividends as long as the payouts are kept within an IRA account
  • as long as dry bulk cargo ship lease rates are stable - the cash flow is stable

My target price (for those not wishing to enjoy the income stream): 16

4. Martin Midstream Partners L.P.

52wk high: 36.72

52wk low: 29.461

EPS: 4.08

PE: 8.40

Div Rate: 3.08

Yield: 8.9275

Market Cap: 799.84 M

Additional-specific features:

  • ongoing insiders buying
  • well-diversified - offers a variety of services to the energy sector
  • four primary business lines: terminalling and storage of fuels, natural gas services, sulfur services and marine transportation
  • history of distributing profits
  • continuous yield and dividend growth
  • focused business - selling non-core assets
  • reducing exposure to the volatile natural gas gathering and processing as well as to certain natural gas liquid commodities

My target price (for those not wishing to enjoy the income stream): 40

Conclusion

My A-Team is comprised of high-dividend paying stocks that are first and foremost being run solidly by a strong and reliable management. Taking advantage of high dividend yield stocks isn't a risk-free play. Where there's a return - there's also a risk.

Nevertheless, the A-Team represents four stocks with what I consider a very attractive risk/reward profiles. Do your homework before investing in high paying stocks in order to avoid the high volatility that might be associated with the potentially high income that these stocks are generating.

Don't get tempted to those that seem to be paying too high. "Too high" for that matter usually equals non-sustainable. I find these four stocks to be sound and attractively valued and therefore, highly recommends to investors to grab the opportunity of benefiting from both high yields as well as from potential capital gains.

Source: My 'A-Team': 4 High Dividend Yield Stocks That You Should Hold And Not Let Go