Before I begin this article, I would like to clarify that I’m writing it from the perspective of a total return-oriented value investor who focuses on the high-yield sector. As I detailed in a recent article, I believe that it is one of the easiest sectors to consistently win in by pursuing a highly concentrated, actively managed investing strategy. That said, for investors who purely care about generating passive income from quality stocks and do not like to trade much, especially for the sake of minimizing taxes, I completely understand if you would want to hold some of the stocks that I will be discussing in this article. Without further ado, let’s dive into the five stocks.
#1: Main Street Capital (MAIN)
I believe that Main Street Capital is a great dividend growth stock and is actually one of the best business development companies (BIZD) of all time. Due to its internal management and practice of issuing equity at large premiums to NAV and reinvesting it effectively, it has consistently outperformed.
However, I’m avoiding it right now because it is very overvalued. It currently trades at a whopping 64% premium to its net asset value, compared to its historic average premium of 49%. Additionally, its 6.5% forward dividend yield is pretty attractive but remains quite low compared to its historic averages of 7.4% given the current elevated interest rates.
Moreover, Main Street’s portfolio has only 67% exposure to first and second lien loans, making it more aggressively oriented at a time when cracks are starting to form in the sector with non-accruals and pricing issues as middle-market companies begin to fully draw down on their credit lines, as reported in Ares Capital’s latest earnings call. As a result, we simply think that the risk-reward here is not favorable.
Of course, for investors who are simply in it for the dividend and the long-term dividend growth, we don’t see too much cause for concern as the dividend remains well covered, the balance sheet is in strong shape, and the company’s underwriting metrics remain sound. As a result, we think that the company will likely continue to pay out its current base dividend and likely continue to pay out specials and even grow its dividend over the long term. We just expect some valuation multiple contraction to hit and for growth to be quite slow in the coming years, leading to subpar total returns.
#2: Ares Capital (ARCC)
Another high-yield stock that I’m avoiding right now is Ares Capital. Despite having an attractive 9% forward dividend yield and an impressive long-term track record that is almost as impressive as Main Street’s, having significant spillover income that helps make its dividend quite sustainable for the foreseeable future, and a solid balance sheet, Ares has some issues. Management has noted on its last few earnings calls that it is sensing a weakening in some of its underlying portfolio holdings, and also expects defaults to spike in the sector this year.
Despite that, its price to NAV is now sitting at a near 10% premium, which is quite significant given that its historical average is to trade right in line with NAV. While it does enjoy the backing of large alternative asset manager Ares Management (ARES), it charges extremely high management fees relative to many of its peers. When combined with the headwinds facing the sector and the rich valuation, we just do not see it as an attractive proposition from a risk-adjusted standpoint. That said, like with Main Street, its dividend should be sustainable for the foreseeable future at 9%, which is pretty solid for an income investor.
#3: AT&T (T)
Moving out of the BDC sector, another high-yield stock that I’m avoiding right now is AT&T. As discussed in a recent article, while the company does appear to be nearing an inflection point on its debt, it continues to have difficulty generating top and bottom-line growth as its revenue and earnings per share both fell in Q1 despite very aggressive investments in its business model. This is driven by a rapidly declining legacy business that still composes a large enough portion of the overall business to be a headwind for the foreseeable future. On top of that, the company has a horrible track record and has delivered very weak returns for years.
Meanwhile, the EV/EBITDA ratio is relatively in line with its historical average, and its dividend yield of 6.5%, while attractive, is not expected to grow much more than 1 or 2% per year for years to come. With little growth or valuation multiple expansion expected for the foreseeable future, we just do not see the appeal of holding AT&T stock for a total return-oriented investor. Once again, though, the dividend should be safe, making it a decent option for income-focused investors, but we see little to no appeal for investors who focus on total returns.
#4: Pfizer (PFE)
Another high-yield stock that we’re avoiding right now is Pfizer. As we detailed in a recent article, the company has a large percentage of its revenue coming from patents that will expire this decade. As a result, it is very dependent on the success of its current development pipeline, which puts it in a quite speculative space. Moreover, it has a large debt burden that it needs to be focused on reducing, and despite that, its valuation is not particularly attractive at the moment. While it could be a big winner if it’s successful in its pipeline, it is also a bit risky, and we do not see the 5.8% dividend yield as being attractive enough to make it worth the gamble.
#5: Kinder Morgan (KMI)
The fifth and final high-yield stock that we’re avoiding right now comes from the midstream space: Kinder Morgan. While the business has reached an inflection point in terms of its leverage ratio, now sitting comfortably within the company’s target range, and its recontracting headwinds have dissipated for the foreseeable future, management has continued to double down on its lower-than-inflation 2% annualized dividend growth rate despite having the capacity to grow much faster. Moreover, instead of buying back stock or growing its dividend rapidly, it continues to double down on so-called growth investments. However, it does not expect its annualized growth rate to move much higher than mid-single digits for the foreseeable future.
While we think it’s a decent stock, the 6% dividend yield with only 2% dividend growth does not make it an attractive choice in a sector where you can get numerous stocks that have higher current yields and higher growth rates, such as Enbridge (ENB), Enterprise Products Partners (EPD), Energy Transfer (ET), and TC Energy (TRP), among others. As a result, we see little to no reason to buy Kinder Morgan stock right now.
Investor Takeaway
While these five dividend stocks all offer very attractive yields that should be safe for the foreseeable future, as a total return-oriented value investor, I simply see no reason to buy them. As a result, I am steering clear of them for now in favor of much higher conviction opportunities that should help me to continue to generate significant outperformance of the broader market.
Read the full article here