Here’s a question: “Stocks of Z Bhd consistently pay high dividend yields. As such, is it a given that Z Bhd is a winner?”

You might be surprised to learn that the answer is no. Once upon a time, this writer would have said “yes” – when presented with two stocks, A Bhd and B Bhd, he would have picked the one that offered a greater dividend yield despite poorer fundamentals.

For example, if A Bhd was a strong company that offered 3% in yields, while B Bhd was weaker but offered 6%, A Bhd would have been the obvious choice. But it might also have caused him to lose money.

The decision as to which company to put your money into depends on your investment process – that is, the steps taken to select the stocks you wish to invest in, and to calculate the valuations of these stocks.

Let’s use the example of two dividend investors, Mr A and Mr B. Mr A’s investment process can be summarised as follows:

• Use screeners and financial media to find high dividend-yielding stocks.
• Check their track record of dividend payments to ensure consistency and quality.
• Discard the ones that are highly priced as they are not affordable.
• Buy the ones that are affordable, if their prices are right.

Meanwhile, before investing, Mr B enters any stock into his four-point process, as follows:

• Study its business model and operational statistics.
• Assess its financial results to ensure it has consistent earnings growth.
• Find out its latest growth initiatives.
• Calculate its valuation ratios – P/E ratio, P/B radio, and dividend yields.

So, would you invest like Mr A or Mr B? There are pros and cons with both approaches.

Mr A could obtain a list of dividend stocks much more quickly than Mr B would, giving Mr A the advantage of speed. But does this translate to higher return at lower risk in the long run? Not necessarily.

Mr A’s process may fail to filter out stocks that have poorer business fundamentals despite paying more. These include companies with consistently decreasing sales and earnings that are struggling to grow.

Mr A, as such, is at risk of falling into value traps.

As for Mr B, his process includes a detailed study of a stock’s annual reports, quarterly reports, and corporate announcements. It would definitely be a lengthy process as it involves a lot of frog kissing to find the one that turns into a prince or princess – and he’s likely to meet a lot of toads along the way.

Nevertheless, Mr B is less prone to value traps.

By no means is this writer discrediting the use of screeners and financial media to select stocks. These can be helpful in narrowing down your search, but they can’t tell you a lot about the company’s business models, financial results, management style, or growth initiatives.

As investors, it’s crucial to understand these to avoid losses. A stock’s increase in dividend yield must be backed by growth in revenue and earnings, and consistent positive cash flow – otherwise, even if the company can pay rising dividends, it’s likely to be a toad.

This article first appeared in KCLau.com. Ian Tai is a financial content writer, dividend investor, and author of many articles on finance featured on KCLau.com in Malaysia, and ‘Fifth Person’, ‘Value Invest Asia’ and ‘Small Cap Asia’ in Singapore.