Dividend Bonanza or Dividend Bust?

Chris is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Dividends are one of my favorite parts of investing. While I have no idea when the "right" time is to buy and sell, I know that a regular dividend will theoretically keep paying me for a long time. While there's no guarantee of a dividend, when there's a fairly long past history and a solid business model in place with ample profits, the likelihood is reasonable.

I think dividends are the most important part of investing in general because they're the only way I can really see profiting off of a company's actual operations. While there is definitely truth to the notion that over the long haul the market functions as a weighing machine, I don't like any investment that demands I sell it in order to make any profit. A dividend is the purest form of ownership-based reward because it's money the company actually makes from its operations (in most cases), instead of just selling the company to somebody who'll pay a higher price for it.

So how are we gonna build a dividend bonanza? By doing research! Yeah, it's not all sexy.

Why I Use My Preferred Metrics

I believe that the ROE of a company is vitally important because the net income over the equity (net of liabilities) is a measure of how well management is using what they have. If I can make $.25 on the dollar you give me (assuming that's all I have after liabilities), that's a 25% ROE. The capacity to make resources produce profits is, in my opinion, the gold standard behind every company's operation. I don't care how big you are or how big of a moat you have, if you're being wasteful you're not going to last very long. You certainly aren't going to churn out the kinds of dividends (nor the reliability of them) that'll hold attention.

Profit margins are a strange metric, but I feel they're useful in clearing up how much cash a company actually has to work with. Now this is a muddy situation because for most companies, the class A share dividends are paid before the profits are calculated and the common stock is paid out of the profits. But I like knowing there's a veritable river of cash pouring out of a company's operation instead of a funnel trying to scoop up a pond of stagnant water. Without profits, the shouldn't be a dividend (and I'm looking at you, big auto companies).

The P/E ratio, is one of the three best indicators of whether I can currently get a good deal on a company. I remember reading The Intelligent Investor and noting that Ben Graham was most interested in companies with a P/E under 10. I don't give a crap what "the market average" is today -- it'll change tomorrow. I don't change my investments like I change my shirts, so I continue to give shorter shrift to P/E ratios over 10 than at or below it regardless of what's popular right now. If I get a good deal, that's a good dividend. If the share price goes up later, that's fine -- I gladly participate in DRIP (dividend reinvestment) plans.

Four Options

Magic Software (NASDAQ: MGIC) is a mobile software, cloud services and other business development company that got my attention because its dividend yield came back in my stock screener as 79.7%. Uh huh, you don't say. Let's check on the dates of those dividends. Yep, that return came from a special dividend. So even though Magic carries a solid 16% ROE and a 9.54 P/E ratio with a 12.75% profit margin, I'm giving it a pass. That's kind of a heart-breaker, but some things are just too good to be true. Like that dream I had about the cheesecake that grows back every time you eat it. Let's move on.

Mesabi Trust (NYSE: MSB) is nice because it's all about the iron ore in the Peter Mitchell Mine in Minnesota. Mesabi was formed in 1961 and has been paying a reasonably steady dividend since at least 1990 (when Dividata's records on it began). The good news is a 97% profit margin because Mesabi only receives royalties, outsourcing the mining and distribution operations elsewhere. The ROE is a beautiful 719% as a consequence of this, but herein lies one of the problems Mesabi faces. Since it outsources most everything, an issue within another company can quickly become Mesabi's problem. Imagine a person who can't move very well being dependent on someone else to do their lawn maintenance, laundry, cooking, etc. Life is reasonable for the physically challenged person as long as the able-bodied individual works as needed. But dependency usually becomes a hindrance at some point, and it's always a bargaining chip knowing you can do something the other person can't but that they desperately need. There's naturally going to be some tension between Mesabi and its partners regarding payment for services rendered. Also, the dividend yield is sporadic, going from as little as $.07 per share to $1.13 per share within 2012 alone. I'll pass.

Capstead Mortgage (NYSE: CMO) is another REIT. I love dividends, and real estate investment trusts are the steaks of this meal -- or the delicious central tofu component for those of you who don't eat meat. In the case of Capstead, it's a mixed bag. The 13% ROE is okay, the P/E of 7.37 is pretty good and the 12.4% dividend is respectable. I also appreciate the roughly 90% profit margins. However, Capstead has the issue that it's dropped its dividend a lot of times over the past few years. While this is to be expected for a company with a 24-year payment history and experience in dealing with recessions, I don't have to like it. I hate having my hopes built up and then stomped on. My ex did the same thing, and this time I'm not getting involved. Pass.

Chimera Investment (NYSE: CIM) really shouldn't be named after a monster. A penny stock with a 17% ROE and a 4.69 P/E, this company deals with a lot of risk and presents just as much in exchange for its 17.2% dividend. Naturally, there's the risk that the Fed will raise interest rates sooner rather than later. Then there's the risk that the company's non-agency loans have nothing securing them and could thus become total losses. Finally, this dividend has dropped more times than... nevermind, that could've gotten crude. Let's just say that Chimera doesn't pay a trustworthy dividend, and if I wanted to go out on a limb and hope for a great return I'd hit the slot machines. 

The Quest Goes On

I'm going to have to continue this into a series. My drive for great dividends has become a quest, and these companies simply aren't up to snuff in my opinion. While I try to always deliver at least one good company in every article, sometimes I fail. This was a dividend bust, but the game never stops.

pongun has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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