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". 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 and 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 because it looks like the yield is increasing. The problem with this logic is that it actually rewards a stock for tumbling in price - you see the point? Indeed, in some cases, the company might be about to go bust.
Broadly speaking, we can think of three types of dividend traps:
i) A Cow Feeding Itself Its Own Milk - This is FIMG's evocative (but rather grim!) phrase for the situation where a company has deteriorating fundamentals but attempts to maintain its dividend policy, usually financing the payout with debt. As we've discussed, companies are often reluctant to lower dividends, so some companies end up paying out dividends even though they are not supported by income. This is highly likely to end in tears.
ii) A Falling Knife - This is where an apparently compelling yield is actually the result of a substantial drop / freefall in the price of a dividend paying stock, ie. the market anticipates substantially lower future earnings of the company in question. Because earnings ultimately drive dividends, a sustained drop in anticipated earnings usually foreshadows a dividend cut or, in severe cases, bankruptcy.
iii) Fools Gold - This is where a company decides to pay a large dividend in one year without any intention for this large dividend payment to persist. This might be the result of a windfall, such as a disposal, and naive extrapolation of this payment level into the future - without looking at a company's dividend history and the circumstances of any recent dividend increases - will lead you astray.
7 Warning Signs of a Dividend Trap
If investors are not careful, they may be unwittingly lured into one or more of these dividend yield traps, to their dire regret. So, here are some key warning signs to look out for...
1. Does it have Top Quintile / Decile Yield?
As we've observed elsewhere, while it would be tempting to assume that the highest yielding companies would have the best performance results, the evidence from studies that have measured the relative performances of portfolios segmented by yield show that this is not the case. A Credit Suisse study of S&P 500 stocks from 1980 through July 2006 found that deciles 8 and 9 outperformed the highest yielding Decile 10. Similarly, Bank of America-Merrill Lynch divided Russell 1000 constituents into quintiles from 1984 to 2010, again finding that the second highest yielding quintile provided the highest risk-adjusted returns.
2. Does it have a High Payout Ratio?
All good dividend yields must be sustainable. It can be difficult to know what is really sustainable as it depends on the future volatility of earnings, but one good check is via the dividend payout ratio. If a company has deteriorating earnings fundamentals, the percentage of a company's earnings that are represented by dividend payments usually increases. A dividend payout ratio greater than 100% means that a firm paid out more than its earnings as dividends. If its earnings do not recover promptly, this is clearly unsustainable as the firm will be unable to reinvest, reducing its capacity to grow in the future.
In that same Credit Suisse study, researchers found that for companies with a given level of yield, those with lower payout ratios (i.e. more earnings to support the dividend policy) tended to have higher returns. Avoiding firms that pay out more than what they are earning as dividends may be an obvious strategy, two thirds (or a payout ratio of 67%) might be a better rule of thumb. It's ultimately an arbitrary number but reflects the need for some margin of safety.
3. Does it have a limited Dividend History?
The dividend's history is a rich seam of information. The company should have a consistent history of paying out dividends. What trends are you seeing there? For example, are the amounts paid out in the most recent period lower than those are prior? Here, you want to see if this will be a payment that sticks around or one that is simply unstable and therefore will fall to the same levels it was in the past. Is there a history of growing dividends? Companies with growing dividends are signaling confidence about their future earnings. They tend to be stable businesses, well positioned in their markets, that are able to perform throughout market cycles. For that reason, S&P maintains a list of "Dividend Aristocrats", meaning companies that have maintained a policy of increasing dividends for more than 25 years. According to Ned Davis Research, over the past 40 years stocks in the Standard & Poor's 500 index that increased their dividend payout annually averaged a 9.4 percent annualized return, whereas companies that paid a dividend but didn't increase that payout had an annualized return of about 7%.
4. Does the Balance Sheet look unhealthy?
If the company is highly leveraged, and is having trouble meeting its short-term liabilities, then this is going to be a big red flag for the dividend. If the company has recently acquired another company, how did it finance this? Did it make a huge cash payment from its cash reserves or borrow money from banks? We've talked previously about the value of checks like the Altman Score or the Piotroski F-Score as a way of assessing balance sheet quality. Companies with Piotroski scores in the 1-3 range are likely to cause problems.
5. Is it a small-cap?
The small cap market is of course a wonderful hunting ground for potential market inefficiencies but, notwithstanding the recent lessons from the banking sector, it remains true that larger-cap companies tend to be more stable. As we've discussed elsewhere, work by Bank of England analysts Andrew Benito and Garry Young found that smaller scale of a business is correlated with an increased chance of a cut.
6. Is it a high beta stock?
One measure you can use to judge a potential dividend pick is its "beta." Used by traders, beta measures how much the stock price moves up and down relative to the whole market. Thus, a "high" beta stock is prone to wider swings in either direction compared to the broad market, while a stock with a "low" beta is less volatile. Like anything, it's not a silver bullet and beta has its critics. A low beta stock could tumble in price and/or suffer financial troubles but, in general, it looks more likely that a high beta stock with a high dividend yield could turn out to be a dividend trap.
7. Does it have poor price momentum and/or relative strength?
This check is used by Russell Research as part of their Russell High Dividend Yield Index Series. They filter out the bottom 10% of stocks based on 12 month price momentum. This is designed to protect against the price "freefall" dividend trap and to mitigate exposure to companies with deteriorating financial health. As they note:
"In December 2008, dividend yields for companies such as Morgan Stanley, Astoria Financial Corp and TCF Financial Corp were all above 6%. Without the momentum screen, these companieswould have been included within the index solely because of the yields that resulted from their price freefalls".
In a similar way, a Charles Schwab study ranked the highest yielding stocks by 6 month price momentum, divided them into 5 segments, and found that highest yield stocks with the highest 6 month price momentum outperformed all the other momentum segments.
In truth, avoiding dividend traps is also about qualitative analysis - identifying companies with a sustainable competitive advantage and a robust operating model. However, the above quantitative flags / question can be a handy short-cut to help avoid low-quality, risky companies that could make a chop in the near future. We'll be putting all this criteria together in a screen to identify a list of potential Dividend Traps as part of Stockopedia PRO. The fundamental lesson for now is... before you divide into a stock with a crazily high yield, ask yourself whether the market is usually so crazy, after all. Low priced, high yielding companies are likely to be cheap for a reason!