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In my last article “20 Relatively Safe and Cheap Dividend Stocks for Income Investors", I highlighted several companies paying decent yields with quality franchises and global operations (getting out of Dollars is more important than stock picking in my mind). High quality dividend paying stocks should be fully researched and many dividend investors can rebalance their portfolios toward higher quality, out of favor Blue Chip companies paying 3% or higher yields without chasing last year’s returns. Many dividend payers are located overseas or have a global customer base which should help investors protect against a collapse in the Dollar.

In this article, I want to suggest to retired readers the importance of portfolio rebalancing and liquidity in times of crises and stock market panics. Additionally, I want to address the temptation of purchasing high yield stocks regardless of their free cash flow streams or business moats to help shed light on what makes a dividend paying stock a good value versus a risky speculation. The worst idea I can imagine is for a dividend investor in retirement to chase a risky high yield stock at all-time highs because they are worried about “missing the rally.”

For a bit of perspective, I want to first take the time to temper investors whose insatiable appetite for returns (along with an ever expanding monetary base) have driven a crack-up boom in stock markets. Nothing goes straight up forever – you don’t have to be Isaac Newton to understand that concept. If we are heading for hyperinflation, investors should borrow money to buy gold and silver, not dividend stocks. I have written several articles this past year on the risks of the US Dollar and have pointed readers to some strong stocks and ETFs to hedge their Dollar risk (from about August on) such as Freeport-McMoran (NYSE:FCX), VALE, Chevron (NYSE:CVX), the RJA Agriculture ETF, SLV, the AGQ ultra silver ETF, the DBA ag ETF, the commodity ETN DJP, the GCC commodity ETF, Seaboard Corp. (NYSEMKT:SEB) and others.

The yield and income problem for retirees is multi-faceted; the elderly cannot find work in this economy, food prices are rising much faster than passive incomes, savings rates are negative in real terms, and Social Security and Medicare seem to be at risk in the medium and longer term future. What all of this means, is that retirees and income investors should avoid making hasty investment decisions based on inflation panic or a broker recommendation and instead should thoroughly analyze the cash flow and balance sheet statements of the stocks they rely on for income during their golden years.
Stock market investing is no different from Newtonian Physics in the sense that what goes up must come down and vice versa. Go ahead and put some money into the Norwegian Kroner, Canadian or Australian Dollar, the Swiss Franc, Singapore Dollar, Brazilian Real, or the Mexican Peso – You never know how bad things can get with our current Dollar crisis and deficit problem as Bernanke is essentially making an all or nothing bet that the overvalued stock market MUST keep rising no matter how insane that seems; See Graham Summer’s recent piece on the matterof Monetary insanity. Just because your neighbors are all holding US dollars, does not make cash under the mattress, muni bonds, or long dated treasuries a safe inflation adjusted investment right now and the same goes for many dividend stocks that investors have flocked to for “income and safety.”

The insatiable thirst for yield is completely understandable, but must be evaluated from an objective and unemotional perspective if one wants their savings to outlive them – it’s either hard work and constant research or taking up smoking Marlboro Reds in your 80’s if you are an average American retiree these days (a regular Joe like me) and want to leave something behind for the next generation. Investors should understand that the market is not somehow bulletproof now -- after the 100% rally there is no “all clear” argument from a valuation perspective in the average REIT or MLP issue right now. Buying an overvalued stock is simply not a good hedge against inflation. In actuality, I would argue equity investing is much more risky today than it was in March of 2009. Valuations are much higher on a Tobin's Q basis today, which may make the tantalizing yields of some dividend stocks appear irresistable to income starved investors who have bills to pay. However, many of the high yield investments over the longer term could turn out to be the apple that you wish you had left on the tree. Take these top yielding stocks for example:
SPG – Simon Property Group looks pricey at first glance at 20X free cash flow and 30X earnings. The 3.2% yield can be found in much cheaper names such as McDonald's (NYSE:MCD), Lorillard (NYSE:LO), Pepsico (NYSE:PEP), Pfizer (NYSE:PFE) -- you name it… Investors should not view REITS as secure because they are in some separate uncorrelated asset class – REITS are cyclical and have done very well over the past two years. In other words, some REITS are better values than others at current prices.
WWE – World Wrestling Entertainment makes a fortune off of the imaginary, make believe battles between scantily clad grown men wearing face paint and Halloween masks, but with the addition of the more believable and barbaric UFC the competition for entertainment dollars could be a strong headwind for this business. While WWE exhibits strong cash flows, the 12% forward dividend yield appears to be funded by increasing leverage and not increasing cash flows from operations as yearly dividend payout appears to be slightly higher than the company’s operating cash flows.
SUI – Sun Communities earned around $60MM in operating cash flow in 2009 and spent $45MM of that on capital expenditures to maintain and grow operations. The $52MM in dividends paid in 2009 was at least partially funded by increasing debt and leverage and not free cash flow. Over the trailing twelve month period, SUI earned around $11MM in free cash flow, yet it paid out $52MM in dividends. How did they pull this off you might ask? Well, the company did issue around $19MM in stock in 2010; which should make investors a bit nervous when looking at the 7% plus dividend yield paid by the company.
FGP – Ferrell Gas Partners shows a 7% dividend yield but a 54X PE ratio and negative $400MM plus net tangible deficit. In the trailing twelve month period, FGP earned roughly $50MM in free cash flow yet paid out nearly $150MM in dividends to shareholders. Investors should be concerned about the solvency of the company which looks pretty overvalued based on free cash flow to enterprise value.
LPHI– Life Partners looks like a bargain, but the SEC is investigating the company’s brokered life insurance contracts as many who invested money in the contracts expected their counterpart insured to “hurry up and die already.” Those investors who bought coverage (if I'm reading this correctly, the company lets individual investors speculate on how long their insured clients will live) on some healthy stranger who refused to push up daisies have grabbed the attention of the SEC which may make LPHI stock dead money or worse for the foreseeable future. Personally, I think the investors were the greedy as well – why not buy CDS instead or invest in a tobacco, homecare, hospice, funeral homes, or a defense company – at least you can make some money there and it's not too good to be true. If the SEC drops the investigation, LPHI could be a good value at these levels.
LGCY – Legacy Reserves earned roughly 50MM in operating cash flow over the past twelve months, yet it paid out $80MM in dividends and spent nearly $190MM on capital expenditures over the past year. The company’s net deficit of negative $4MM does not exactly provide investors with a meaningful margin of safety from a balance sheet perspective.
BKS – Barnes & Noble jumped 7% Tuesday on news that Borders (BGP) would be filing for bankruptcy. Although this does not really groove with the earlier rise in the stock on news that Borders was going to acquire Barnes & Noble, many investors likely believe that BKS will be able to take market share with the closing of their biggest brick and mortar competitor. Interestingly, despite all of the hype about the digital revolution killing off book stores; electronic books accounted for roughly 4% of total book sales in 2010. BKS boasts a 6.3% dividend yield, yet the company has negative $263MM in net tangible book value and has basically been free cash flow negative since 2008. Investors looking at the yield should realize that BKS lost over $700MM in tangible asset value over the past three years and may not be able to survive with such an over leveraged balance sheet. Whether or not the hundreds of millions the company sunk into the E-reader to recapture the market share it already controls will pay off in time is up to the consumer. However, the 4% digital market share is surely a disappointment to the brain trust behind the Nook. While the market for digital everything is growing, BKS may not be around long enough to reap tech bubble profits.
EDE – Empire Electric is another company which has very little free cash flow, yet has managed to pay a huge dividend yield to investors by issuing common stock and debt to fund dividend payments. While the business could turn around, the fact that the company paid $50MM in dividends over the past twelve months while issuing around $50MM in stock should make investors think twice before buying these shares for the long haul.
TSTY – Tasty Baking is a company that is losing money in a big way, yet keeps paying out dividends like clockwork. One wonders if the company is planning on paying out a dividend right up to a bankruptcy filing, as the company has lost around $22MM over the past three years and only has $15MM left in tangible book value. At a $30MM price tag, the dividend yield does not seem worth the risks of owning shares in the underlying business.
Cheap dividend payers – So far I have tried to illustrate some of the pitfalls of dividend investing, but to be fair I am not saying that dividend paying companies are bad investments. In fact, the only way management teams ever really reward investors over the long term is through returning cash to shareholders via dividends. Here are a few companies to keep an eye on -- most of these names are relatively cheap on a free cash flow basis.
ABT – Abbott Labs is a solid growth company which has compounded investor capital at double digit rates over the longer term. ABT trades for just 9X earnings estimates for 2011 with a 3.9% dividend yield. Free cash flow at ABT of roughly $6 billion seems to be more than enough to payout ABT’s larger than average yield. Investors, however, should focus on ABT’s investing cash flows to see if their acquisitions and investments are creating growth.
MSW – Mission West Properties sports an 8.8% yield and a price to free cash flow ratio of just 5X. MSW appears to be paying out a bit more than they earn in free cash flow, but at 1X book value the company could theoretically wind down and investors could earn some money over the course of the next few years based on recurring cash flows from the operations of the business. I am bullish on Silicon Valley, so I find the company’s commercial office holdings in Silicon Valley to be stable long term investments for shareholders and a good store of value. Now that Bernanke has committed the entire US balance sheet to inflating the tech bubble, MSW may be a great way to play the phenomenon at 5X free cash.
GLAD – Gladstone Capital appears to be earning 80MM or so in yearly free cash flow on a market cap of just $230MM. Low debt to equity and large free cash flows make the 8% yield attractive for investors at current prices. This is a closed end debt fund, so the cash flow numbers I got from Yahoo may not tell the whole story. Still, this closed end fund appears to be relatively undervalued.
RGC – Regal has one thing going for it these days – large depreciation expense and free cash flow. RGC earned approximately $300MM in free cash flow in 2009 and again last year, making the 6% yield sustainable and attractive if you think the movie theatre business will be around for many years in the future. $10 popcorn can help fund a great deal of quarterly income payments for retiree shareholders, however, if the money keeps printing, $10 popcorn may seem like a bargain in a few years.
FORTY – Formula Systems trades at just 3.42X EV/EBITDA and 11X earnings, making the 6.4% yield believable and likely sustainable over the longer term. With a price to free cash flow ratio of less than 9X 2009 FCF, investors should research this Israeli software company further.
SDRL – Seadrill was looking to make acquisitions last summer and may be able to score a win with a play for HAWK or HERO once the drilling ban is lifted and life goes back to normal in the Gulf of Mexico. SDRL trades for just 6X trailing earnings (10.7X forward PE) and pays a 5.8% dividend yield. Strong management with skin in the game makes SDRL a sleeper favorite in the drilling sector.
In conclusion, wise investors looking to replace their bond income with dividend payments know that all yields are not created equal in the equity markets. Some companies pay a dividend right up to their Chapter 11 filings so make sure free cash flow covers most or all of the dividend payments made to investors over the past few years and quarters. Watch the trends in the top line and in the investing cash flows segment to make sure the income stream from these stocks is secure and sustainable over the long run. After all, even though everyone wants to live long and prosper, most retirees need to work harder than ever to avoid outliving their savings. Physical gold and silver may end up being the best store of savings for the next few years if governments continue to kick the can down the road.



Disclosure: I am long MCD, LO, PEP, VALE, DBA, GLD, PSLV.

Source: Dividend Investing: Make Sure Free Cash Flow, Not Debt Issuance, Backstops Your Investment