High Yielding Stocks To Consider Ahead Of The Fiscal Cliff

by: Paul Zimbardo

The looming fiscal cliff has caused extreme market volatility and has forced investors to seek safer stocks. With the economic and political climates becoming more tumultuous, I have been concentrating on high yield opportunities. Stocks with high yields tend to be "safer" because the yield provides a cushion against capital depreciation and inherently implies that the underlying equity has sufficient cash reserves (although not always the case).

Dividend stocks tend to have a strong financial position but it is always critical to check the liquidity and solvency ratios before considering an investment. Blue-chip dividend companies are well-known but there are attractive equities with high yields going ex-dividend every week. This strategy can work in one of two ways: either you buy before the ex-date to receive the dividend or buy after if the stock declines far below the after-tax amount of the dividend. Regardless of your short-term strategies, these equities can be attractive longer-term investments depending on your individual circumstances.

Buying the stock to receive the dividend is intuitive but many have contacted me requesting further details on the second strategy. Investopedia has a great example of how this works. To explain this, I will use AT&T (T) as an example. AT&T declared a $0.45 dividend to shareholders of record on January 10, 2013. On the ex-dividend date the stock price should decline by the after-tax dividend amount, with an assumed tax rate of 15% because many dividends qualify for a preferential tax rate. It is true that you can personally avoid immediate taxation by owning the security in an account with beneficial tax treatment but this serves as a benchmark.

As a result, an investor would expect the stock price to decline by $0.38 = [$0.45 * (1-.15)]. If AT&T declined by more than $0.38 in the absence of negative news you might have an attractive opportunity. For conservatism you may ignore the tax aspects and only trade if the stock price declines by the full dividend amount. Executing this strategy can generate returns over short periods of times but should only be performed on companies that you would be comfortable owning.

To focus on these opportunities I ran a screen with a focus on relative safety for the investments as the objective is to concentrate on liquid companies that are affordably priced. I began with a specification of a dividend yield greater than four percent and an ex-dividend date within the next week. To provide some layer of safety I narrowed down the environment by looking at companies with market capitalizations greater than $1B, PEs between zero and 20, and institutional holding percentage in excess of fifteen percent (except ADRs).

While not a precise requirement, I prefer companies that have underperformed the S&P 500 year-to-date as it indicates reduced downside relative to peers. For example, if negative macro news breaks, the stock that has declined more in the past year should ideally perform better than a similar stock with year-to-date gains. With the impending European crisis I now avoid companies with significant European exposure. This is summarized below:

  • Dividend Yield ≥ 4.0%
  • Ex-Dividend Date = Next Week
  • Market Capitalization ≥ $1B
  • P/E Ratio: 0-20
  • Institutional Ownership ≥ 15%
  • Ideally Modest S&P 500 Underperformance
  • Minimal European Exposure

After applying this screen I arrived at the equities discussed below. Although I envision these as short-term trading ideas, you still need to exercise caution. The information presented below should simply be a starting point for further research in consultation with your professional financial advisor before you make any investment decisions. My goal is to present new companies to you and provide a brief overview of their recent developments and this should not be considered a substitute for your own due diligence.

Note that many companies have been shifting the dates of their dividend payments into December to avoid higher dividend tax rates in January 2013. The dates presented are accurate to the best of my knowledge but are subject to change at any time without warning.

ARMOUR Residential REIT, Inc. (ARR): 15.47% Yield; Ex-Dividend 12/12

ARMOUR Residential REIT is a company that investments in various agency mortgage backed securities which are issued or guaranteed by U.S. government affiliated agencies. As of the most recent quarter, ARR has $22.1B in agency securities opposed by $19.9B in repurchase agreements. ARR is currently levered about 10X (liabilities/equity) which means its relatively low net return (<2%) is magnified ten times. This explains how these agency REITs can sustain double-digit yields despite such low relative returns on assets. Portfolio Management 101 has an excellent overview of ARR and its risks.

As a REIT, ARR must distribute at least 90% of its taxable income to shareholders. Currently ARR distributes 100% of taxable income and may be facing cash flow issues. The company has $193M in cash from operations in the first three quarters while it paid out $187M in dividends to common and preferred shareholders. Such a tight spread is not uncommon for mREITs. ARMOUR simultaneously issued $1.5B in stock which was the financing source that caused cash to increase over the period. With this in mind, the liquidity issue has not been problematic in the last few years as this hot sector of the market has had minimal trouble raising capital due to strong returns. The economic climate could get increasingly more challenging so this is a risk worth noting but insiders have been bullish and I believe you should be as well. With this information in mind, I believe ARMOUR is reasonably priced at 6.5 P/E and has a high enough yield to compensate investors for the risk assumed. Note that ARR distributes dividends monthly.

Ares Capital Corporation (ARCC): 8.69% Yield; Ex-Dividend 12/12
Ares Capital Corporation is a specialty finance company that provides services to diverse middle-market companies with unique financing needs. The underserved nature of the market makes this a highly lucrative segment but it is not without risk in this economic climate. This risk is mitigated by having a P/E under nine which provides a margin of safety: my ears always perk when I hear about a company with a P/E lower than its current yield. Please note that ARCC is one of the largest Business Development Companies ("BDC") under the Investment Company Act of 1940. A nice overview of BDC is provided by IndieResearch but the primary point is that BDCs must distribute 90% of their earnings as dividends. Ares is similar to a private equity that I have owned throughout 2012, Prospect Capital Corporation (PSEC).

The dividend history is a little volatile but the dividend appears to be safe for at least the near-term. There are signs that ARCC is planning on growing as it has been raising equal capital and expanding its revolving lending facility so the situation requires close monitoring. Lending additional support to this hypothesis is Ares' 19M share offering which should raise over $300M in additional equity. Ares declined on this dilutive news but has bounced back as it reported another solid quarter in which it made over one billion dollars in new investments. The portfolio yield stands at 11.6% which is actually lower than the prior period as the company has focused more on higher priority debt lending. The portfolio yield is substantially higher than the stock's yield so concerns about the payout sustainability are negligible. Remember that is normal for these types of companies to continually raise new capital via equity or debt to finance investing activities. Short-term dilutive news is often a buying opportunity.

Seagate Technology PLC (STX): 5.33% Yield, Ex-Dividend 12/12

Seagate is one of the leading computer hard disk drive manufacturers -- where you store your files, pictures, and music on your computer. Technology companies are generally not the highest dividend payers, but the hard disk drive business is relatively mature for the tech industry, so there are more opportunities to return capital to investors. Hard disk drives may be losing popularity in the face of solid-state drives, but until solid-state becomes more cost-effective, Seagate will be able to print money with its legacy hardware.

I recently covered Seagate as one of David Einhorn's top holdings at Greenlight Capital, LLC. Einhorn is a big fan of technology stocks, especially value tech stocks such as Apple (NASDAQ:AAPL). Seagate is cheap by virtually all metrics and sports a 5.16 forward P/E and .3 PEG ratio. The company is cash rich with a current ratio above two and has shown a dedication to returning profits to investors via dividends and share repurchases. I am long Seagate's primary competitor, Western Digital (NYSE:WDC) and I believe concerns about the market are overstated.

NYSE Euronext (NYSE:NYX): 5.11% Yield; Ex-Dividend 12/12
NYSE Euronext operates securities exchanges including the New York Stock Exchange (NYSE), NYSE Arca, NYSE Amex, and Euronext N.V. Stock exchanges have significant news coverage in 2012 as Nasdaq (NASDAQ:NDAQ) mishandled the high profile Facebook (NASDAQ:FB) IPO. Shares are off nearly ten percent in 2012 which has driven the yield up to approximately five percent but I would avoid NYSE for dividend capturing due to the numerous unpredictable external factors. In its most recent quarterly conference call, CEO Duncan Niederauer, reaffirmed his commitment to dividend growth:

"Thirdly, we remain committed to deploying capital in a shareholder-friendly way. In addition to the 2012 dividend and buyback that Mike will touch on, we are continuing to look at opportunities to shift things in businesses that do not support our strategic objectives. We will be looking to divest all or at least a portion of our stakes in LCH.Clearnet and MCX at the appropriate time.

Despite the CEO's bullish comments, I still see substantial risk associated with NYSE and I believe there are more attractive dividend stocks available. With the yield above five percent and forward P/E around ten there is an opportunity here but it is not without risk as earnings continue to decline.

Shaw Communications (SJR): 4.45% Yield; Ex-Dividend 12/12
Shaw Communications engages in diversified entertainment offerings, but focuses primarily on Canadian cable television. Cable companies have traditionally been able to distribute sufficient cash flows to investors but the tides are starting to shift with the rapidly rising cost of content. Sports programming is a double-edged sword because it is one of the biggest advantages over Internet streaming; however, it is the most expensive to offer. This is still a 'cash cow' industry but it is changing too quickly for me to fully support investing in it.

Factor in the popularity of Internet connected television and other devices and I am not extremely bullish on the traditional entertainment content business model. I do not believe that investors are being adequately compensated for the level of risk assumed and the companies mentioned above offer comparable (or higher) yields for less risk. Five percent seems to be that magic yield number for this type of 'utility company' that draws support and that could occur again with Shaw. The stock has been a surprisingly strong performer and has climbed over 11% this year. Personally I would consider one of the stocks above with higher growth and yield prospects.

Garmin (GRMN): 4.29% Yield; Ex-Dividend 12/12

Garmin is a company that specializes in global positioning systems ("GPS") technology, specifically stand-alone GPS receivers for automobiles. I have been bearish on Garmin for quite some time as I do believe that the valuation works for an industry that faces a steep decline going forward. Revenues and earnings continue to decline at slow rate but the company has no debt and its strong liquidity/solvency position should keep the company chugging along for the near future. The dividend is respectable and was just recently increased but I cannot recommend Garmin for either an investment or dividend capture. On the positive side, the company recently announced that it will be joining the S&P 500 index after the close of trading on December 11th and that could provide a short-term catalyst that could make this into a one-time strong dividend capture candidate but only if you are willing to assume the risk.

NorthWestern Company (NWE): 4.23% Yield; Ex-Dividend 12/12

I recently wrote a detailed explanation of how I analyze utility companies and in brief I focus on the number of customers and geographic location. Larger companies enjoy scale benefits and are able to profit more from smaller rate increases. While geographical differences exist for regional utilities, the underlying business is essentially the same: a stable, cash-cow business that returns most profits to investors via dividends and share repurchases.

NorthWestern Company services 700,000 customers in Montana, South Dakota, and Nebraska. The company recently swung to a quarter loss of $3.8M due to one-time impairment and revenue deferrals. Aside from these nonrecurring charges, total revenue is also declining due to weakness in gas revenue. Given the geographic region and the company's poor recent performance, I would look towards a higher quality utility company for investing.

The information presented has been summarized below. Yellow and red represent "avoid" and "consider" classifications, respectively.

(Click to enlarge)

Please refer to profile page for disclaimers.

Disclosure: I am long AAPL, PSEC, T, WDC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Please refer to profile page for disclaimers.