April 30. 2012 9:00AM

When seeking income, beware of the highest-yielding stocks

On the Money

By Michael Kops

As investor frustration with low yielding traditional income-oriented investment vehicles like savings accounts, CDs, and Treasury bonds increases, looking at dividend-paying stocks as a way to generate or increase income makes sense. But beware of high market valuations and unsustainable yields.

The income chase has driven up the price of stocks that pay the highest dividends. In fact, recent data from Bernstein Research shows that investor demand for high dividend yields means that company valuations are now more influenced by high dividend payout ratios than by high profitability.

Intuitively, this preference for payouts over profits makes little sense for the long-term as, ultimately, a company can only sustain dividends if it is profitable. We conducted research at Heartland that ranked dividend payers into five groups based on levels of dividend yield. The results show that the very highest-paying dividend stocks have historically not been the best performers. In fact, the second highest yielding group actually had the highest total return.

This has been true over both short- and long-term holding periods. The very highest payers often end up stretching to make payments beyond the company's ability to generate profits. These stocks can become yield traps with attractive yields but poor underlying fundamentals—and could be vulnerable to sharp corrections when investors become pessimistic.

To help avoid yield traps, consider companies that have gradually grown their dividend payout ratios over time. Dividend paying companies with lower payout ratios possess a greater likelihood of sustaining and growing their dividend payments as dividend growth often signals a company has demonstrated fiscal prudence and effective free cash flow management. Furthermore, the Bernstein research also says that dividend growth is not currently overvalued, like dividend yield.

In this environment of persistently low interest rates, it may make sense to explore dividend-paying stocks as a way to boost current income. However, we encourage you to be mindful of anything that looks too good to be true.

Michael Kops is vice president at Heartland Advisors in Milwaukee.