How To Avoid Dividend Traps

by: The Outsider

Income investors usually screen for high-yielding stocks when they are researching new investment ideas for their portfolios. However, too much dividend yield may sometimes be a bad thing. The simple reason for this is that very high-dividend yielding stocks are most probably distressed and dividend cuts may already be priced in. Dividend cuts are more common in the higher-dividend yield space, thus just focusing on these stocks may lead to higher risk and volatility within investors' portfolios. Furthermore, very high-yielding stocks are also less common in the marketplace, which can result in an under diversified portfolio. Therefore, instead of focusing solely on high-yielding stocks investors should research dividend quality trying to predict and avoid dividend cuts as their primary goal, with a view that a steady income stream and lower volatility should duly follow.

Despite being several years on from the global financial crisis of 2008/09 and the aftermath of collapse in dividend payments, dividend distributions still remain volatile around the world. The percentage of companies recording lower dividend payments than in previous years is still high, particularly in Europe and Asia despite the fact that payout ratios are typically higher than in the US. On a country by country basis, the high-dividend yield universe has historically been dominated by the UK, Australia and the US. This is partly explained by favorable taxation (Australia), or an institutional investment base that favors dividends (UK and US).

Some factors that are widely followed such as earnings coverage and historical track records, aren't necessarily the most useful ones in predicting dividend cuts amongst high-dividend yielding stocks. Instead, as dividends are paid in cash, investors should focus on the company's balance sheet strength, profitability, and cash flow generation capacity. The idea is that companies that are profitable, growing and self-financing are more likely to pay and sustain the higher-dividend yield. Also, share price volatility and performance may also be other important factors as they signal the market's confidence on the company's sustainability over the long-term, due to the market's forward-looking bias. This methodology to research high-quality dividend companies is also supported by several index providers, which revised their methodologies recently to incorporate these ideas. For example, MSCI has changed its methodology for its MSCI High Dividend Yield Index:

Enhancements to the existing MSCI High Dividend Yield Index methodology incorporating additional screens that exclude stocks based on certain "quality" characteristics and recent 12 month price performance. The quality scores are calculated using fundamental variables such as returns on equity, earnings variability and debt to equity.

Investors are also increasingly looking towards capital appreciation and the prospect of high-dividend payments in the future through dividend growth. For this, monitoring dividend and earnings momentum can also be worthwhile. For instance, through analysts' estimates for the next year's earnings and dividends, investors may be able to predict dividend cuts and avoid pain in their portfolios. Additionally, investing globally may offer better growth prospects, especially in emerging markets, and should help diversifying dividend risk away. Finally, I would recommend yield-based investors to most of the time avoid the banking sector. As shown during the global financial crisis of 2008/09, the industry's 'voodoo' accounting and its reliability in short-term funding makes it especially vulnerable to economic/financial crisis and, in my opinion, does not provide the necessary safety for long-term investing barring some few exceptions.

In short, income investing is much more than just to look at which stocks have high-dividend yields. Investors should do their due diligence, focusing on dividend quality instead of quantity. Thereby, dividend cuts should be avoided, which are the main risk income-investors face over the long-term. As I discussed recently, I think McDonald's (MCD) [article link here], Philip Morris (PM) [here], Roche (OTCQX:RHHBY) [here], and Statoil (STO) [here], may be good long-term holdings for yield-based investors because all of them have solid business fundamentals, stable levels of revenues and earnings, and good cash flow generation capacity, which should be supportive for their dividend payments even during economic downturns. For those willing to take more risk, Linn Energy (LINE) may be a good choice, as I discussed in my previous article Linn Energy is a major opportunity. Despite the recent negative sentiment towards Linn Energy due to its accounting practices, I think the company's fundamentals are solid and investors are well compensated (12% yield at current stock price) to see how this story plays out over the next few months.

Disclosure: I am long STO, LINE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.