3 Potential Dividend Yield Traps

Not all high-dividend stocks make great investments. In this segment of Industry Focus: Financials podcast, host Michael Douglass and Fool.com contributor Matt Frankel take a close look at three high-yielding stocks to explain why they could be yield traps.

A full transcript follows the video.

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This video was recorded on April 30, 2018.

Michael Douglass: Of course, we're not going to just keep this theoretical. We have three examples of companies that we wanted to vet as potential yield traps. Of course -- I'm going to say it again because I'm sure there are shareholders in these companies who are listening, some of whom are really excited about these companies. That's totally fine. We're not saying they're yield traps. What we're saying is that, by certain criteria, and we'll walk through those criteria, these are potential issues that shareholders or prospective shareholders should be aware of. And they're why you and I, Matt, personally, are staying away from them. But, of course, your mileage may vary. Your investment goals may vary. And that diversity of viewpoints and opinions is one of the things that we believe makes for a great investor community.

So, with all that in mind, let's talk through CenturyLink, ticker CTL. First step: yield unusually high.

Matt Frankel: Yes. [laughs] Telecoms are generally on the higher end of the spectrum. AT&T and Verizon are, typically, depending on when you're looking, within the 4-6% range as far as yield. CenturyLink is over 11%. So, I would call that unusually high.

Douglass: Yeah. Double is one of those strawmen that you set up as, "Yeah, that's definitely there." And, excessive debt. Their debt-to-equity is 1.6:1. AT&T's, by comparison, just under 1.2:1. So, that's a pretty big difference. So, it definitely checks that box, too. Let's talk about payout ratio.

Frankel: CenturyLink made an acquisition recently, so their earnings are a little distorted, so we'll get to the cash flow in a minute. Even so, they pay out over 100% of earnings as dividends based on both the past 12 months and the next two years of analyst projections, which, as Michael said, an acquisition will distort your earnings for about a year. In this case, it's over 100% for a three-year period.

Douglass: Yeah, definitely concerning. Little or negative cash flow. They generated positive cash flow for the past two years, but they paid out dividends that were in excess of their free cash flow in 2017.

Frankel: Yeah. The free cash flow, which is the operating cash flow minus the expenses, the difference between those two was more than the dividend they paid out last year. So, that's concerning. That checks that box.

Douglass: Yeah. And, of course, problems with the business.

Frankel: Not necessarily. I don't see anything wrong with the telecom sector in general or CenturyLink's business. So, that would be four out of five in this case.

Douglass: Yeah, which is, again, for us, fairly concerning. Let's talk about Annaly Capital Management, that's ticker symbol NLY. Unusually high yield? Yes. It's 11.5% as of this morning, which is high.

Frankel: Yeah. No matter what industry you're talking about, a double-digit dividend yield is going to be high. Annaly is what you call a mortgage REIT, which is a real estate investment trust, but instead of buying properties, they invest in mortgage securities. Getting to the second point, excessive debt, the way mortgage REITs do this is, if you say you can borrow at 2% interest and buy a mortgage that pays 3%, that 1% difference is called the spread, which is your profit. Nobody wants a 1% return on their investments. So, these companies will borrow a lot of money in order to make big dividend yields like the 11.5% Annaly pays out.

In full disclosure, I've owned Annaly in the past. I don't right now, but I have in the past. And I'm not necessarily calling this a yield trap, as Michael said. But, there are certain risks involved with this stock, and this system can help you look a little deeper and realize what you're getting into before you buy one of these.

So, speaking of the excessive debt, Annaly's debt-to-equity ratio is almost 6:1, which is typical for a mortgage REIT, but is very high by any metric.

Douglass: Right. Then, of course, payout ratio. This is one of the areas where nuance matters. It's about 90% of funds from operations that Annaly is paying out. That's a little high for a real estate investment trust, but it's not really that high, so it doesn't actually check that box. Even though, you hear 90% of essentially the REIT version of earnings, and you think, "Well, that seems like a really high payout ratio," actually, for REITs, it's not necessarily. I've seen REITs that have really very successfully paid out dividends over a long time period right around that amount. So, it doesn't actually check that box. Even though, in pretty much any other sector, that would be a concern. Of course, cash flow is an issue.

Frankel: Yeah. Their cash flow statement shows negative cash flows for the past four quarters and for three out of the past five years. That's a concern. There's really no way around that. Three out of the past five years, they've paid out more money in total expenses than they've taken in.

Douglass: Yeah. And, of course, problems with the business. At the moment, there doesn't appear to be any. Rising interest rates are putting some pressure on real estate investment trusts in general. Because they are such debt-laden businesses, dependent on debt to grow, they struggle in a rising rate environment because they basically have to find increasingly high-yielding investments to then successfully be able to pocket that spread that Matt talked about earlier.

Of course, the other piece of this is, this is a company that's basically betting on mortgages. That can get a little dicey if, let's say, the housing market turns. And I'm not saying the housing market is going to turn any time soon, but at some point -- we were all around during the financial crisis, and we can see what kind of damage that can cause. So, there's a lot of risk attached to this dividend yield, even though right now, there aren't any really big problems with the business. So, Annaly checks three of the five boxes.

Let's talk about CBL & Associates Properties, that's ticker symbol, as you might guess, CBL. The yield is almost 20%.

Frankel: Yeah. So, that in itself should tell you to stay away.

Douglass: Yep.

Frankel: In this case, checking one of the boxes may actually be enough. But, let's go through the whole thing. CBL & Associates is an equity REIT, meaning that they actually own properties. They own shopping centers and malls, but not the really great kind. They own what are called B and C-level malls, which are the secondary, the older malls, things like that. Not the Galleria, these are the smaller malls.

They pay out almost 20% as of this morning. Just looking at their debt level, their debt-to-equity is 3.7:1. For REITs, you want to see closer to a 1:1, if that. So, they have an excessively high level of debt as of right now. Their payout ratio is not excessive just yet, but the problem with them is, they have declining earnings, first of all, and they have a lot of retailers in their malls that are in trouble. So, payout ratio is not excessive yet, but it's very possible it could be in the future.

Douglass: Yes, so, it makes sense for us to go ahead and jump forward to the fifth thing, problems with the business, right now. We'll come back to No. 4, which is little or negative cash flow, in a second. Problems with the business, yeah. Their malls and shopping centers have lots of exposure to troubled retailers, particularly Sears and JCPenney.

We've all heard, probably, about America's dying malls. I used to live near one. CBL seems to be highly exposed to this potentially major issue. This is one of the reasons why you're seeing earnings starting to decline, which again, makes that yield really concerning.

Cash flow is low, but it's not negative, so it doesn't actually check that box.

Frankel: And just like I said with the payout ratio, it's not negative, yet. It easily could be. Just to give you, this statistic scares me away from it, 60% of CBL's properties are anchored by either a Sears or JCPenney. [laughs] So, that alone should scare anyone who knows anything about the retail business away from investing in that company, especially if you think their long-term outlook is going to be nice.

Douglass: Right. So, CBL & Associates checks three of the five boxes, at least from our interpretation. So, that's our take on three potential dividend yield traps.

Matthew Frankel owns shares of AT&T. Michael Douglass has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Verizon Communications. The Motley Fool has a disclosure policy.