7 Deadly Signs of a Dividend Yield Trap

Sunday, Jul 01 2012 by
7 Deadly Signs of a Dividend Yield Trap

After decades of being eclipsed by capital appreciation in investors' minds, formerly-dull dividend plays are once again right back in the forefront of investors' minds. The simple explanation for this is that, in times of slow growth and low interest rates, investors are looking for safety and yield, for companies that are “bondish”.

US blogger, The Reformed Broker, has aptly called this thirst for dividend stocks "income worship" which is a great turn of phrase – investors are feverishly seeking the safety & quality of bonds but also wanting to take the next step up the risk/return spectrum.

Don't chase yield blindly...

However, there's a danger for investors in focusing too hard on income. A naive yield strategy may lead you SMACK into a dividend trap. This is akin to the dreaded value trap which we've discussed elsewhere. It is where dividend yields are high, but not sustainable. Dividends, unlike bond coupons, are not certain cash flows. A dividend that is too high, relative to the earnings generated by a firm, will meet a sticky end eventually.

Blogger, Wall Street Daily rightly argues that, while both types of trap are dangerous, the dividend yield trap is yet more so. With a traditional value trap, the stock goes nowhere but investors don't usually end up sacrificing much capital in the process, whereas:

A high-yielding stock with poor fundamentals is often forced to cut its dividend. And when that happens, watch out! Investors get hit with a double whammy. Not only do they lose the income they coveted, they also get handed a sizeable capital loss, as stock prices often plummet after dividend cuts".

Beware the Yield Trap

The important point to remember is that, just because "dividends are good", it doesn't follow that the highest dividend yield must be the best. There is a point at which high yielding dividend-paying stocks actually become riskier than the average stock. To illustrate this, let's say that a stock's annual dividend per share is £1. The stock price for the stock is £10 per share. This means that you would take £1 and divide it by £10 to get a yield of 10%. If the price of the stock plummets to £5 per share, you would then take £1 and divide it by £5. The new yield percentage is 20%. This might look even juicier to you…

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