With bond yields at extremely low levels, income-hungry investors have bid up the prices of U.S. dividend-paying stocks. But that could be leading them into risky territory since many companies have excessively high payout ratios, says Stephen Groff, a principal and portfolio manager at Cambridge Global Asset Management, a unit of Toronto-based CI Investments.
"What we have seen among a subsector of stocks, particularly the higher-yielding companies, is that they are paying out a higher percentage of their earnings than they have historically," says Groff, a member of the team that manages the $300-million CI Cambridge U.S. Dividend. "And people are paying a higher multiple on those earnings. Or, put another way, earning a lower yield. That's not a good combination for the highest-yielding subsector of U.S. stocks."
Citing research on the U.S. large-cap universe provided by Robert W. Baird & Co., a Milwaukee-based financial-services firm, Groff notes that over the past four decades the median payout ratio of the highest quartile of dividend payers has risen progressively. Since 2005, the median payout ratio has climbed from about 60% to above 75%. In contrast, the payout ratio for the universe has moved from under 20% to about 30%.
"Part of the reason that companies are allocating an increasing portion of their earnings to shareholders is they are getting paid to do it," says Groff. "In today's market, if you raise your dividend, investors are happy, period -- even if it's not the right thing for the business long-term."
In addition, over the past five decades, Groff notes the traditional discount between the price-earnings ratio of the highest quartile of dividend payers, versus the universe, which has existed for over decades, has virtually disappeared. "The gap has been there a long time and made sense because a lot of these companies are mature and not growing so quickly," says Groff. "But as fund managers are allocating more money to income-oriented stocks, it has pushed down the discount. The highest-yielding stocks are disproportionately expensive relative to their lower-yielding peers."
In his view, investors who have bought exchange-traded funds that focus on companies at the upper end of the payout ratio are assuming considerable risk. "These ETFs just screen for the highest-dividend payers," says Groff. "There's no fundamental analysis. No one asks: Is the company run by smart people? Are the managers aligned with shareholders or good at allocating capital?"
Groff argues that investors should be concerned about issues such as valuations. "Relative to the growth that many of these businesses can generate, I believe that many are fairly expensive. If you have a move in interest rates, I'm wondering, what's going to happen to these stocks?" says Groff. "They are being valued like bonds. They could be vulnerable."
As stock pickers, Groff and chief market strategist Robert Swanson, believe it makes more sense to focus on companies with lower payout ratios. "That's where the value is. We're not finding value among the highest quartile of dividend payers. They have less margin of safety," says Groff. "We believe in making sure that we are being paid to take the risk. Every stock has to make sense on a bottom-up basis."
Indeed, a company's dividend yield is secondary, says Groff. "The dividend is only one small piece of the puzzle. A company can have a great dividend but be a horrible investment," he says. "For us, the dividend does not drive the decision. It's the company itself."
Attributes that Groff looks for include management that is aligned with shareholders, competitive advantages that enable the company to generate outsized returns and grow, and good capital allocation. "Having a management team that knows what to do with cash flow is paramount. It's so important for a dividend fund because some companies keep raising dividends but at a faster pace than their earnings. That's why their payout ratios keep rising, which is not sustainable long-term," says Groff.
"Sometimes it's better to lower their leverage or invest more in the business or to buy a competitor," adds Groff. "For us, it's important that a management team knows how to allocate capital. That's what differentiates a great company from a good one."
Among the names that Groff cites in a concentrated portfolio of 30 companies is 
"They are streamlining their products and investing in growth. And they are using the cash flow to buy back shares, which we believe makes sense," says Groff, adding that the payout ratio is 40% to 50% of adjusted earnings. "The dividend is very secure."
In a similar vein, Groff likes
"As a combined company it is becoming more efficient," says Groff, adding changes are being driven by new senior management. "They generate strong free cash flow. Long-term there is room to buy back shares and raise dividends." The firm pays a 1.5% dividend, Groff adds, and its payout ratio is 38%.
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