Investors love dividends (you wouldn't be reading this otherwise). And we're naturally drawn to high yields. So anytime a stock's payout climbs two to three times above the market average, you can bet it will get a hard look.
If the business is on solid financial ground, then it won't take long for income hunters like us (as well as larger institutional investors) to pile in, driving the shares up and the yield back down.
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If that doesn't happen, there might be a good reason -- just like a house that sits for sale on the market for months and months with barely a nibble. If there's a yield that high can't attract buying interest, then Wall Street is sending a message that the dividends don't appear to be sustainable.
Playing High-Yield Detective
General Electric (NYSE: GE) shares have been in a freefall for months, driving the yield toward 5%. But even at that level, few seemed willing to take the risk. A corporate spokeswoman tried to reassure investors by insisting that "dividends remain a top priority." But just last week, the company slashed its quarterly distribution in half.
If it can happen to a blue-chip like GE, it can happen to anybody.
So when it comes to screening for ultra-high, double-digit yielders, I go in with a healthy amount of skepticism. In fact, I find it's best to adopt a "guilty until proven innocent" mindset. In other words, I automatically assume that the payouts are on shaky ground unless I can uncover compelling evidence otherwise.
That starts by determining how much cash is coming in the door -- and how much is going out. Some businesses generate strong operating cash flows, but are naturally capital-intensive. For every dollar in profits, they might have to plow 95 cents back into maintenance and upkeep. That doesn't leave much on the table for dividends. So I pay close attention to non-discretionary CapEx spending and free cash flow levels.
Then we have to dissect the balance sheet and ask some tough questions. What is the potential impact of rising interest rates on borrowing costs? Is the company at risk of a credit rating downgrade? It's not just absolute debt levels that matter, but the timing of maturities. If liquidity is tight and refinancing options few, then a looming principal repayment in six months might spell doom for dividends.
Such research requires digging, but there is one simple (yet highly effective) screen you can run yourself. It involves searching for companies with high distribution coverage ratios -- at least 100%, ideally 120% or more.
I just ran it on a fresh pool of 10% yielders using 2018 earnings estimates. Not surprisingly, only a small handful (out of hundreds) is expected to earn enough to cover their dividends next year with room to spare. And here they are:
If I Could Only Choose One...
Of all the double-digit yielders in my screening universe, Knot Offshore Partners (NYSE: KNOP) has the strongest coverage ratio. The company is currently distributing annual payments of $2.08 per share, and the average earnings estimate for next year is $2.51 per share -- for a comfortable coverage ratio of 121% ($2.51/$2.08).
If accurate, then Knot Offshore will earn $1.21 for every $1.00 in dividend payments. And at least one analyst is anticipating even higher earnings in excess of $3.00 per share.
This limited partnership owns a fleet of 13 shuttle tankers, which are specialized vessels used to transport crude from offshore oilfields to coastal refineries. The stock has been fairly resilient the past few years, despite the downturn in oil prices and subsequent slowdown in offshore drilling. It bottomed below $14 in December 2015 and has since rebounded back above the $20 mark.
The company has certainly done its part to win investor support. Fleet utilization is outstanding at 99.7%. And third-quarter revenues ($58.2 million), EBITDA ($45.1 million), distributable cash flow ($24.0 million) and net income ($21.1 million) all set new record highs.
As a result, the dividend coverage ratio is also the highest in company history. And we're not talking about a 4% or 6% payout either -- but greater than 10%. The biggest concern is the $1.0 billion debt burden, a quarter of which is subject to rate fluctuations. But I think it's manageable, particularly given the company's steady fixed charter-based income stream.
KNOT is better suited to risk-tolerant investors but deserves a closer look. It has earned a spot on my watch list for my premium income newsletter, High-Yield Investing.
This Is Just A Start
The goal of this stock screen is to identify stocks that are worthy of a closer look. While they have already met my simple distribution coverage criterion, I haven't fully researched the companies in the table above. If I find a real gem within these screens, a stock that can actually maintain this level of yield through the years to come, my High-Yield Investing subscribers will be the ones who benefit the most.
So if you'd like to join us in our search for the best high yields the market has to offer, then I want to invite you to learn more about High-Yield Investing. You don't have to settle for the paltry yields offered by most stocks. The high yields are still out there. You just have to know where to look -- and my staff and I are here to help you along.
This article originally appeared on StreetAuthority.