Stock Quotes in this Article: FE, LO, O

BALTIMORE (Stockpickr) -- When times are tough, it’s no surprise that investors flock to dividend stocks, seeking to grow their portfolios through high yields when capital gains aren’t cooperating. But not everyone’s a fan of dividend-paying stocks -- in fact, many are being actively shorted by investors who are hoping to profit from a decline in share price.

In some ways, dividend stocks have a lot to lose. With the emphasis placed on their dividend payouts, failure to meet investors’ income expectations can have a gory impact on a stock’s share price. But well-positioned dividend stocks are tough to bet against in the long term for the very same reason; investors are loath to sell an income payer as long as the stock is consistently paying out its income to investors.

For those reasons, some of the best short-squeeze opportunities can be found among high-yielding dividend stocks.

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    A short squeeze is the buying frenzy that ensues when a heavily shorted stock starts to look attractive again to investors, causing share price to skyrocket. One of the best indicators of just how high a short-squeezed stock could go is the short interest ratio, which estimates the number of days it would take for short-sellers to cover their positions. The higher the short ratio, the higher the potential profits when the shorts get squeezed.

    Naturally, these three plays aren’t without their blemishes -- there’s a reason that these stocks are being heavily shorted. But for investors looking for exposure to a speculative play with a beefier risk/reward tradeoff, these could be powerful upside plays for the coming year.

    With that, here’s a look at high yield stocks with short squeeze potential in 2011.

    FirstEnergy

    The last year has presented a fairly challenging environment for power utility FirstEnergy (FE). All told, shares of the Ohio-based power company fell 16% in the last 12 months. But the paring down of the firm’s share price has at least provided new investors with a higher yield income play -- the stock’s current annual payout rings in at $2.20 per share.

    But that’s precisely why short sellers are targeting this firm. With a short interest ratio of 12.5, it would take two-and-a-half weeks for shorts to cover their positions at current volume levels.

    FirstEnergy is more diversified than most traditional utilities. The company has nearly 14,000 megawatts of power generation capacity, a number that’s soon to increase substantially when the acquisition of Allegheny Energy (AYE) is completed. All told, the deal will give FirstEnergy a much larger footprint in its regulated utility business, which benefits from a high level of recession resistance. Meanwhile, the company has been working hard to grow its other business lines, particularly the merchant generation business.

    While energy generation is a very capital-intense business, the company’s cash flows should be more than adequate to secure its dividend payouts under current conditions. And with a history of payout growth behind them, investors should benefit from a return to higher levels of profitability as demand increases. 

    That’s the hope of investors like the Franklin Utilities Fund (FRUSX), which owns shares of FE in addition to stakes in Entergy Corporation (ETR) and PG&E (PGC).

    Jean-Marie Eveillard at First Eagle Investment Management also owns shares of FirstEnergy, at 1.7% of the total portfolio. According to WallStreetNewsNetwork, it's one of the highest-yielding electric utility stocks. TheStreet Ratings rates FirstEnergy a C hold.

    Lorillard

    For $11.5 billion cigarette maker Lorillard (LO), the cause of investors’ anxieties is the FDA. That’s because the government agency is stirring up new questions about the health concerns of menthol cigarettes, Lorillard’s signature niche of the tobacco market. As a result, the company currently sports a short-interest ratio of 10.4.

    Lorillard owns the Newport brand, the dominant name in menthol cigarettes. All told, the brand owns 35% of the menthol category and contributes more than 94% to Lorillard’s revenues. While it’s unlikely that menthols will be banned outright, investors are deeply concerned that new regulations could impose extra regulations on Lorillard, decreasing the company’s ability to market its product.

    Ultimately, that’s probably a good thing for the company because increased scrutiny from the FDA is keeping competitors from stepping in, and focusing too many new resources on the incredibly profitable menthol category. Expect Newports’ share of the market to continue growing in 2011.

    The company’s 5.84% dividend yield should continue to attract investors like the aptly-named Vice Fund (VICEX), a mutual fund that invests exclusively in morally questionable companies. Other holdings include Diageo (DEO) and Lockheed Martin (LMT).

    Other major holders include Renaissance Technologies, at 2.1% of the total portfolio, and David Williams at the Columbia Value & Restructuring Fund, at 4.4% of the total portfolio. With a B- buy rating, the stock is one of TheStreet Ratings' top-rated tobacco stocks.

    Realty Income

    Retail REIT Realty Income (O) has had some significant economic headwinds blowing against it in recent years, as both retail and real estate crumbled around its balance sheet. But the trust persevered throughout the recession, ultimately proving itself to Wall Street as a financially viable income investment.

    Like many popular REITs, Realty Income is a conservative trust that enters into long-term, triple-net leases with its corporate tenants. As a result, the trust benefits from recurring, predictable revenues that aren’t tied to the financial performance of the real-estate market. And because of the stock’s structure as a real estate investment trust, shareholders lay claim to 90% of those revenues on a monthly basis. That makes this stock an attractive choice for investors who are looking for strong income plays.

    While Realty Income’s exposure to retail and real estate will continue to plague the firm with short-sellers, the trust has already proven itself through one of the most challenging markets most investors have ever faced. In December, it was one of several stocks increasing their dividend payouts.

    Expect those dividends to continue flowing to owners such as the WisdomTree MidCap Dividend Fund (DON). The fund owns shares of Integrys Energy (TEG) and Kimco Realty Corp (KIM) in addition to its stake in Realty Income.

    For the rest of this week’s short-squeeze opportunities, including Pitney Bowes (PBI) and Cherokee (CHKE), check out the at High Yield Stock Short-Squeeze portfolio at Stockpickr.

    And to find short-squeeze plays of your own, be sure to check out the Stockpickr Answers community for insights and investment ideas.

    -- Written by Jonas Elmerraji in Baltimore.

    RELATED LINKS:

    >>Top 10 Warren Buffett Dividend Stocks
    >>11 High-Yield Stocks to Consider Now

    >>3 Uptrending Short-Squeeze Stocks

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    At the time of publication, author had no positions in stocks mentioned.

    Jonas Elmerraji, based out of Baltimore, is the editor and portfolio manager of the Rhino Stock Report, a free investment advisory that returned 15% in 2008. He is a contributor to numerous financial outlets, including Forbes and Investopedia, and has been featured in Investor's Business Daily, in Consumer's Digest and on MSNBC.com.