One of the traps that income investors often fall prey to is buying tasty high yield securities that turn toxic. What they forget is the tried and true principle that in order to get greater reward, you have to take on greater risk. Often, these are issued by companies in trouble. Sometimes the companies right themselves, so you can get away with reaching for return. But other times you get smacked for your troubles later by way of capital losses that more than offset the dividends you pocketed.
Note that I just said “sometimes.” It’s also true that there are rare occasions when what tastes really good is actual good for you. The reason: the underlying business model is sound. The thing is, they’re not easy to find, and you have to know what you’re looking at. I spend a good amount of my time hunting for these treats, and I want to bring to your attention three choice morsels I’ve found with high but sustainable yields.
Medallion Financial Corp. (NASDAQ:TAXI) is exactly the kind of oddball investment I love. It’s a low-volume stock (under 200,000 shares a day) hiding in plain view with rock-solid economics that aren’t going to change any time in the near future. Its raison d’etre is the fact the governments of various cities, such as New York, have decreed that one must have a special license, or “medallion,” to operate a taxi. By limiting the number of medallions, a city artificially puts a cap on the number of taxis (now you know why you can’t get one in the rain) operating within its limits.
Consequently, because demand for medallions exceeds supply, the medallion cost is very high (now a cool $1 million in New York City) and must be financed. Enter Medallion Financial. This is a business with no real capital expenditures and no cost of revenue. Thus, net margins are 23%. TAXI just has a lot of cash and no business to expand, so it pays it out in the form of a 7% dividend. And no, I don’t view UberX — which links riders to car services via a mobile app – as a real threat. There’s no replacing a real taxi cab.
Annaly Capital Management (NYSE:NLY) is a mortgage real estate investment trust, or REIT. These companies are able to borrow money at low interest rates, then use the proceeds to invest in securities that are known as Government-Sponsored Entity Mortgage Backed Securities, or GSE-MBS. These securities pay a very healthy interest rate themselves, thus Annaly profits from the spread between the two rates. It then throws the income off to its shareholders. Right now it’s paying an annualized dividend of $1.20 per share for a yield of 10.3%.
Right now, NLY is in a healthy rebound after coming under some pressure from the rise in interest rates off their historic bottom that started in 2012, marked by a 2013 spike due to uncertainty over Fed monetary policy. From an all-time high of $14.44 in Q4 2012, the stock tumbled to $9.12 a year later, but has since climbed back to $11.86 as interest rates have leveled off, as the Fed has clarified its approach to tapering its bond-buying program. It’s trading at a bargain PE of 4.3, a 6% discount from its book value of $12.30 a share,and analysts see a return to earnings growth. The yield and business model makes Annaly a buy here, but if interest rates resume their rise, you’ll want to sell out, since Annaly’s spread will decline.
Fifth Street Finance Co. (NYSE:FSC) is known as a Business Development Company (BDC). These entities operate under special rules that allow them to invest in middle market, bridge financing, first and second lien debt financing, expansions, acquisitions, add-on acquisitions, recapitalizations and management buyouts in small and mid-sized companies. They often charge interest in the low- to mid-teens and take an equity kicker in the form of warrants to purchase the company stock. These entities also spin out much of their income to shareholders. FSC pays an annualized dividend of $1.00 per share; with the stock now at $9.27, that’s a yield of 10.8%.
The key is that Fifth Street does its due diligence and doesn’t invest in risky operations that end up defaulting. Fifth Street has $2.7 billion invested in companies and is only around 25% leveraged, so FSC has a wide margin for error should investments have to be written down. Meanwhile, 99.5 percent of its investments are performing at or above the company’s expectations. Moreover, it’s one of only six BDCs whose debt is rated as investment grade, it recently received and upgrade from S&P from “stable” to positive, and recently created a senior loan fund facility that should enable it to tap the capital markets going forward at an advantageous interest rate.
About Lawrence Meyers
Larry is regarded as one of the nation’s experts on alternative consumer finance. He consults for hedge funds and private equity via his Council Member status at Gerson Lehman Group, and as a member of Coleman Research Group’s Executive Forum. He also consults for Credit Access Businesses and Credit Services Organizations in Texas. His Op-Eds and Letters to the Editor have appeared in over two dozen major newspapers. He also brokers financing, strategic investments, and distressed asset purchases between private equity firms and businesses of all stripes. You can reach him at email@example.com.
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