Investing indiscriminately in high-yielding dividend stocks can be quite risky. This can be explained by the old adage: if it’s too good to be true, it usually is.
Dividend stocks with high yields are often yield traps. This means that the dividend is high because the stock has fallen or the payment is at risk of being cut or even suspended. Reasons for dividend cuts or suspensions may include high debt loads and declining profitability.
But every now and then, there are exceptions to the rule. Capital Main Street (MAIN 0.03%) i Financial Prudential (PRU -0.23%) they appear to offer safe market-beating dividends to income investors. Let’s dig a little deeper into why each of the two stocks could be smart buys for investors with some capital to invest.
1. Main Street Capital: A BDC of the highest quality
Main Street Capital is a business development company (BDC). These types of companies invest in other companies that generally do not have the ability to secure financing in traditional ways, such as through a bank loan or the sale of bonds.
Main Street Capital focuses on the underserved lower middle market. These are companies with annual revenues between $10 million and $150 million and earnings before interest, taxes, depreciation and amortization (EBITDA) of $3 million to $20 million. The BDC in exchange for extending credit takes significant stakes in these companies and/or receives above-average interest income.
With $4.5 billion in capital under internal management, Main Street Capital is highly diversified. As of September 30, the company had debt and/or equity interests in 195 companies. The largest single investment in the portfolio represented 3.3% of Main Street Capital’s total investment income and 3.2% of the fair value of the total portfolio. Given that the company’s highest industry exposure was just 8%, in the Internet software and services industry, the BDC is also well-diversified across dozens of industries.
BDCs can avoid corporate tax as long as they distribute a minimum of 90% of their taxable income to shareholders. This explains how Main Street Capital is able to offer investors a dividend yield of 7.4%, which is more than four S&P 500 yield of 1.7% of the index.
Since becoming a public company in 2007, BDC’s monthly dividend per share has soared 105% to $0.225. With a dividend payout ratio that has reached 91.7% over the past 12 months, Main Street Capital should be able to continue to deliver slow and steady dividend increases going forward.
The icing on the cake is that the stock has an attractive valuation. At the current share price of $37, Main Street Capital trades at a price-to-earnings (P/E) ratio of just 11.5 months.
2. Prudential Financial: A solid insurer and asset manager
As long as there have been equity markets, there have been asset managers. And with $1.35 trillion in assets under management as of Sept. 30, Prudential Financial is among the top players in the industry. And if the company’s leadership status in the asset management industry wasn’t enough, Prudential is also a dominant life and disability insurer: the second largest insurer in the US based on net premiums written .
An investment in Prudential is a double bet. First, that institutional investors, such as pension funds and mutual funds, and retail investors will demand asset management services in the coming years. Second, that employers and individuals will continue to purchase life and disability insurance policies. These are certainly pretty safe bets for the future.
With a dividend payout ratio of around 50%, that makes the generous dividend yield of 4.7% pretty safe. And at the current price of about $101 per share, income investors can grab shares of the stock with a forward P/E ratio of 8.6. For context, that’s significantly below the asset management industry’s mid-term P/E ratio of 14. By any measure that makes Prudential a bargain.
Kody Kester has positions in Main Street Capital and Prudential Financial. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.