Investing basics: It's a trap! Dividend traps and how to avoid them

Dividend-paying stocks are often seen as higher quality and more stable than their non-dividend-paying counterparts. For income-orientated investors, they're the next step up on the risk/return spectrum between lower-risk bonds and higher-risk growth stocks.

But there is a point at which dividend-paying stocks become riskier than the average stock. A company's dividend yield can lure investors into risky corners of the market, exposing them to financial distress, dividend cuts, and share price declines.

In this two-part article, we'll discuss what dividend yields are and why investors can get caught out. Next week we'll explore some of the ways investors can avoid this siren song.

What are dividend yields?

Dividends are the income component of shareholder returns. They are the portion of profits that a company may decide to pay out to investors (effectively, the owners of the company). The amount of dividends paid usually fluctuates according to the performance of the company.

Dividend yield is one of the oldest valuation methods. It gained in popularity as dividends became a key reason why people – chiefly income-oriented investors – sought to own stocks.

In its simplest form, dividend yield is equal to a company’s annual dividend per share divided by a stock’s market price.

Dividend Yield = (Annual Dividends per Share) / (Stock Price)

For example, a company that pays an annual dividend of $1 per share and trades for $20 has a dividend yield of 5 per cent.

Dividend Yield = $1 / $20
= $0.05 (or 5 per cent)

Remember, the share price and dividend yield move in the opposite directions. If that same stock’s price rose to $40 a share, its dividend yield would fall to 2.5 per cent —the more expensive the stock, the lower the yield.

Dividend Yield = $1 / $40
= $0.025 (or 2.5 per cent)

Conversely, the yield can rise if the stock price decreases or the dividend payout increases.

Why the focus on dividend yields?

Karl Siegling, portfolio manager at Cadence Capital, says the investment community has become fixated on dividend yield, particularly the self-managed superannuation fund (SMSF) investor.

He says there are several reasons for this:

• SMSF retirees use these dividends to live on and the higher they are, in principle, the higher their standard of living.
• SMSF investors pay much lower than 30 per cent tax so that the excess amount of tax paid is, in effect, "refunded" to SMSF investors.
• Interest rates globally have been falling steadily and are now at historically low levels so that fully franked dividend yields look much more attractive than interest on cash in the bank or term deposits.

Exercise caution

Dividends accounted for more than 50 per cent of the returns from investing in Aussie stocks over the past decade, and dividend payers can be a clearer route to long-term returns.
So, the case for investing in companies that pay dividends is a strong one. Stock up your portfolio with high-yielding stocks – seems logical, right?

As with all valuation ratios, dividend yield must be used with caution. Companies that boast very high dividend yields might seem like bargains, but they may be too good to be true.
Such companies could be going through financial problems that have caused their stock price to plunge (and the yield to rise). It’s not unusual for companies in such situations to cut their dividend in order to save cash, so their actual dividend yield going forward might be lower than the currently reported figure.

The "trap" comes in when investors are lured by the promise of a high dividend yield and favourable tax advantages. Later they discover that the company’s fundamentals are shaky, which in turn causes the income and the share price to fall.

An example of this familiar to many Morningstar readers is Telstra. Telstra's stock price had been falling since mid-2015.

However, investors tolerated the poor stock price performance on the condition the company maintained its attractive fully franked dividend. Dividend yield crept up as the stock price plummeted, peaking at around 9 per cent in November 2017.

In a bid to preserve balance sheet strength and operational flexibility, Telstra was forced to cut its dividend from 30.5 cents in fiscal-2015 per share to 16 cents in fiscal-2019.

Another noteworthy example is packaging company Pact Group Holdings. In November 2018 the company's dividend yield reached a 5-year high of 6.71 per cent, as the stock price sunk below $3.50.

Pact had been steadily growing its dividend since 2014, from 9.4 cents per share in fiscal 2014 to 23 cents per share by fiscal 2018. However, in fiscal 2019 Pact's stock price crashed when management reported a collapse in profits. Dividends were suspended.

Don't blindly chase yield

Steve Bruce, an Australian equities and income fund portfolio manager at Perennial, says investors shouldn't view dividend yields in isolation.

"[Dividend yield] isn't the be-all and end-all,” Bruce says. “You want a balance between a company which can pay a reasonable level of dividends and grow earnings over time … because as those company earnings grow, a dividend stream should grow as well.

Financial planner Ian Bailey, co-founder of Bailey Roberts Group, agrees. "Yes, we take it into consideration, we add it into the equation for measuring the intrinsic value of the stock, but to me, it's more important to buy something of value than purely based on dividend yield.

"If you lose 5 per cent in dividends, that's something, but if you lose 50 per cent of the stock value, that has a far greater impact than your dividend being reduced … it's important to have a broader understanding of the business that you're buying into," Bailey says.

Next week, we'll explore how investors can spot a dividend yield trap lurking on the balance sheet.