One of my favorite scenes in the classic James Bond spoof Austin Powers is when Powers sits down at the blackjack table occupied by Dr. Evil’s Number 2. (see “Bond Investing. JAMES Bond Investing.”)
Number 2’s cards give him 17…and because he “likes to live dangerously” he says “hit me.” (Number 2 has x-ray vision that lets him see that the next card was a 4, but that is not particularly important in this metaphor.)
Power’s cards give him 5…and because he “also likes to live dangerously” he decides to stay.
Of course, Powers loses to the house. It is mathematically impossible to bust when you have a total of five; you would need at least two more cards to exceed 21. So Power’s decision to stay was not living dangerously; it was a case of not understanding the rules of the game.
This is how I feel when I see investors chasing yield in some dodgy sectors of the market. Not only are they living dangerously, they are failing to appreciate that they are taking risks at all.
I’ll start with mortgage REIT Chimera Investment Corp (NYSE: $CIM), which yields an impressive 13.7%.
When you hear “REIT” you automatically think of productive real estate. But that is not at all what Chimera is. In fact, it has far more in common with a high-flying hedge fund than it does with a staid old real estate investment. Mortgage REITS like Chimera play the spread game, borrowing large sums of money cheaply and investing it (generally) in mortgage bonds and their derivatives.
The ability of mortgage REITS to maintain their massive dividends depends on the spread between the short-term rates at which they borrow and the prevailing market rate on the mortgages they buy. Well…have you checked mortgage rates lately? They are at all-time lows. And with Bernanke’s QE Infinity in full effect, that’s not likely to change.
But let’s say mortgage rates start climbing tomorrow. That’s great for future mortgage purchases, but what about the existing portfolio? It’s book value gets hammered, and the investment manager may be forced to liquidate and sell at a loss if short-term borrowing rates rise.
I’m not telling you to never buy a mortgage REIT. In fact, I myself have a small position in Two Harbors Investment Corp (NYSE:$TWO) in some of the portfolios I manage. My point is that these are not your grandpa’s REIT. If you want stable dividend growth from a pool of real estate, consider something like Realty Income Corp (NYSE:$O). But invest in mortgage REITs at your own risk. (Lest you think I am being dramatic, Chimera has seen its share price swing from $3.16 to $1.81 and back to $2.69 over the past 12 months.)
Next on the list is SandRidge Permian Basin Trust (NYSE: $PER), which yields 14.3%. Oil and gas royalty trusts have become popular in recent years as yield-hungry investors have had a lack of better alternatives. But these should not be confused with oil-and-gas-based Master Limited Partnerships (MLPs).
I love MLPs. They pay high and growing streams of tax-deferred income while (generally) taking little commodity price risk. They operate like toll roads, getting paid for the volume of oil and gas they transport, irrespective of the market price. If bought at a reasonable price, they are about as close as you can get to a perfect investment.
Alas, none of this holds true for oil and gas trusts. The trusts are highly sensitive to the price of energy and to engineering estimates of their reserves. But more than this, they are not going concern businesses; they are depleting assets. You shouldn’t expect long-term capital gains from these; the high income you receive today is all you’re going to get.
Again, this is not to say that you should never buy an oil or gas trust. Under the right set of circumstances, you can make a killing in them. But these are highly-speculative investments and should not be confused for safe and stable dividend producers.
Finally, I’ll throw out France Telecom (NYSE: $FTE) as an example. Investors have flocked to American and European telecom stocks in recent years because the high dividend payouts seemed too good to ignore. I recommended Spanish telecom giant Telefonica (NYSE: $TEF) two years ago primarily for its exposure to Latin America, but its 8% dividend at the time was certainly a sweetener.
Alas, it was too good to be true. With its domestic market in free fall and its borrowing costs surging, Telefonica suspended its dividend to conserve cash.
Though France Telecom did not face a crisis on the level of Telefonica, it too recently had to cut its dividend, from €1.40 to €0.80. This dropped the yield from the mid teens to about 9% today.
Even at the reduced payout, France Telecom is one of the highest yielding stocks in the world. But it operates in a brutally competitive market. Telecom services are a commodity where the dominant factor to consider is price. Given that the mobile phone market is saturated in Europe, the only way a provider can grow is at the expense of a rival. This is a zero-sum game, and it’s not good for profits. (And this says nothing of fixed-line phone service, which is going the way of the dodo bird.)
Again, I’m not saying that investors should always steer clear of telecom firms. I still own Telefonica because I consider it an attractive growth play in Latin America. But telecoms are no longer conservative utilities. They operate in a brutally-competitive market, and investors should buy at their own risk.
Disclosures: Sizemore Capital is long TWO, O and TEF. This article first appeared on InvestorPlace.