Don't be tricked by high dividend yields

When it comes to high-dividend stocks, it turns out that you often don't get what you pay for.

In this era of low interest rates, investors are seeking out dividend stocks with high dividend yields — the expected annual payout divided by the price. But often those expected yields never come to pass. The actual payout over the next year tends to be much lower, according to new data compiled by Mellon Capital, a BNY Mellon investment boutique.

If yield calculations suggested that an investor should have expected to get back about 9 percent in dividends, those investors actually only earned back around 4 percent, according to data from the last two decades. Those investors would have been better off investing in companies that pay in the 6 to 7 percent range, which returned an average of more than 5 percent.

For companies that offered at least a 10 percent dividend yield, investors actually made only about 3 percent. That's because high-yielding stocks are often priced low for a reason — they could be low-performing companies that are about to cut their dividends.

The data suggest that investors would be better off seeking out companies with middle-tier yields and stronger fundamentals, which ultimately are more likely to pay out a higher realized yield. Understanding the difference between the expected and realized yield can help investors factor in the risk of dividend cuts into their investment decisions.

"It's not a new idea, but it serves to make an important point," said Syed Zamil, managing director at Mellon Capital. "It's always tempting to reach for yield and screen for yield and go for the highest yields, but you need to pay special attention to yield stocks that seem too good to be true."

Mellon evaluates dividend stocks across their fundamentals including earnings growth, upward analyst revisions, strong cash flow, attractive valuation and upward price momentum. Often the best balance between yield and those stable fundamentals is around 4 to 6 percent, said Zamil. Higher yields require careful scrutiny.

"Anything over 10 to 12 percent dividend yield, we don't exclude them but we look at them with a more critical eye," he said. "In every case we're looking at fundamentals, but that's when you need to pay particularly close attention."

Today, four companies in the S&P 500 offer yields over 7 percent and 32 companies have yields over 4 percent. Dividend stocks generally tend to have higher annual returns than the rest of the market during market downturns, and concerns about the market so far this year have driven dividend stocks higher than the S&P as a whole.

"Some have called this one of the most unloved bull markets we've seen in a long time, so it's no surprise that dividend stocks are shining," Zamil said. "Find companies producing stable results that you can get at a discount — that's the sweet spot."