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Looking for Cheap Money? You Could Be Looking in the Wrong Place

Tuesday - 7/16/2013, 1:53pm  ET

Many investors are looking for high income-paying stocks that also offer a level of capital protection. I recently ran a screener to try and identify a handful of worthwhile candidates. This is exactly the kind of search that, say a retiree could be doing; looking for dividend payers but also protection against loss of capital. I ran a screener based on the following three criteria:

  • P/E (TTM) ratio of 8 times or lower -- a low P/E is usually considered to be a "cheap" stock
  • Market Cap of $2 billion or larger (Mid Cap and up, usually less volatility)
  • Dividend of 4% or greater for income

On the surface, one could reasonably assume that this could create a list of solid companies to choose from. And while it does, it can also give an investor without enough knowledge, some potentially harmful choices. Read along, and see if you've made these mistakes yourself:

Valuation requires context

Let's say you are drawn to a group that all pay pretty substantial dividends: mREITs. Factor in all the news you've seen about the rebounding housing market, and the increasing interest rate environment, and it seems like a real solid opportunity to invest in this area:

NLY Dividend Yield data by YCharts

With those yields, nearly any investor would be very tempted to put in a buy order on the spot, right? Since late 2011, all four of these companies, have paid annual dividends that exceed 10%, and more than 15% hasn't been out of the ordinary. Annaly Capital Management  has consistently paid out more than 10% annually, with the exception of the heart of the Great Recession. American Capital Agency ,  has also paid a substantial dividend, in its case averaging well over 15% since first paying a dividend in 2010, about a year after its founding in May 2009. As a bonus, these companies both have market capitalizations in excess of $8 billion. That means stability, right?

I bet there's a catch, isn't there?

There usually is. Here's the beginning: American Capital Agency has two different share types -- common stock, and preferred shares, while Annaly has four different stocks that it trades -- one common stock and three preferred shares. Part of the risk for investors in the "cheaper" common shares is that these shares are the first place the dividend gets cut when times get tough. And the times could be getting tough over the next couple of years. 

It may sound counter-intuitive with interest rates on the rise, but it's not. Here's a simplistic explanation: mREITs make their money on a "rate spread," the difference between what it charges customers in mortgage interest, and what it pays out in interest for the short-term capital it needs to make the loans, plus its expenses. This is very lucrative in the lowering interest rate environment we have experienced over the past five years. 

However, as short-term rates rise, the spread can get thinner, cutting profits. And while it's not impossible for a well-run REIT like Annaly to profit in this kind of environment, there isn't any "easy money." And the very high dividend yields of the past few years were a product of that easy money. 

Add in the extremely low payout of bonds right now, and it could be a perfect storm. And when income investors fear a loss of their income, this is what happens:

NLY data by YCharts

On June 19, Ben Bernanke announced that the Fed would likely start pulling back on its economic stimulus activity later this year. The market responded to his upbeat message with a selloff of REITs -- even as the rest of the market was rallying. While the market has started to edge back up for them in the past week, there's little evidence that this won't happen again, and in a sustained way. And for investors looking to preserve capital, that may not be worth what looks like a nice return. 

What's an investor to do?

The same as always: establish some diversity. I'm willing to go on record that in five years, both Annaly and American Capital Agency could still be paying well-above average dividends, and their share prices will be either similar to today's if not up at least moderately. But for a fixed-income investor that may need to tap into capital to make ends meet, especially if dividends get cut, the potential volatility makes these terribly risky choices as primary income stocks. No level of diversity can prevent the losses of a major recession, as many of us learned in 2009. But having a balanced portfolio will protect us from specific sectors or companies that falter, and right now, mREITs are becoming very volatile.

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