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3 Dividend Traps You Must Avoid
Posted by: The Dividend Guy Blog (IP Logged)
Date: August 8, 2012 07:28AM
To What Point Are You Blind When Looking At Your Dividend Stocks?
Have you ever heard of what investors call the “value trap”. A value trap happens when a stock is trading at a very appealing P/E ratio. Investors think they have found the deal of the year and they buy it without thinking further. The problem is that sometimes, the stock is a value trap: it’s worth a lot today, but the economics around the stock will eventually lead the company to be less profitable. This is why the P/E ratio will never go higher. Investors are then stuck with shares trading at a low P/E ratio but they will never catch up and go back to a higher multiplier. This is the value trap. Now, there are also dividend traps!
Dividend Investing is definitely one of the most popular and successful ways of investing. But it doesn’t mean that it works all the time. The whole point of dividend investing is obviously to get paid regardless what is happening in the markets. Some investors are so used to receiving their dividend distributions that they forgot they don’t own certificates of deposit and they are not receiving interest. Dividends are not 100% secured. In fact, dividend investing can also bring you big losses. There are some pitfalls you must avoid during your dividend investing journey:
#1 The High Dividend Yield TrapIf you have been following this blog for a while, you should have learned that the dividend yield should not be a factor in your investment process. Actually, as long as the dividend yield meets a minimum requirement (mine is set at 3%), you should not prefer a stock because it pays better than another one.
The high dividend yield trap is caused by greed. Investors are nostalgic from the time when we used to have Canadian Oil Income Trusts paying 8-9% with steady monthly distribution (anybody still hold ERF?). If you are still looking for high dividend paying stocks, you are heading towards the high dividend yield trap. This means that you buy the stock for its distribution. Unfortunately, there is a small print at the bottom of your trading slip: it says that the stock is unlikely going to continue paying its high dividend!
In the current market, there is one reason why a stock would pay higher than 5% in dividend; it’s because the dividend payout is not sustainable. If the market doesn’t think that the company will continue to pay its dividend, it starts selling the stock. The price goes down and the dividend yield goes up by default. If the dividend yield has increased significantly over the past 12 months and it’s not because the company is increasing its dividend, you are in a high yield dividend trap. Here are a few stocks that may represent a trap:
#2 The Being Paid To Wait TrapWe often hear about the good side of dividends during bear market as you are being paid to wait. We all know it’s not the right time to sell when the market is down. While your stock might take a 15% slump, you still earn your juicy dividend of 3-4%. This reduces your paper loss and encourages you to keep your stocks longer. But is the distribution enough to keep you waiting five years?
Pfizer (PFE) is a good example. Over the past 5 years, the stock has generated a big 1.66% investment return (dividend excluded) and over 10 years; we are at -17.91% (as at July 31st). Is the 3.64% dividend distribution enough to wait that long? It’s even worse in the case of PFE since they cut their dividend back in 2009 during the financial crisis.
Closer to my portfolio, my recent experience with ZWB proves that the dividend yield is not enough to keep you waiting. After a year, I lost money on this trade while making a juicy 8% dividend yield. However, when I combined my dividend payout with the portfolio value, I was still at a loss. I sold ZWB and bought STX (Seagate Technology) instead. This is how I made by my money back in just three weeks. Will I continue to ride STX now that their latest results missed analysts estimate for the first time in 5 quarters? That is a pretty good question!
Because we buy dividend stocks for dividend growth.
Because we buy dividend stocks with a long term view.
Because we get paid quarterly for our patience.
Dividend investing also causes procrastination! We comfort ourselves as investors by thinking that we are not day traders and that we should buy solid companies paying steady dividends. This is why so many investors want to keep their investments for life. But the problem is that they keep the wrong stocks in their portfolio for too long.
Receiving a check every three months should never be a reason to keep a stock. Don’t become a lazy investor because you are watching your dividend yield more than you look at your portfolio value. You might be holding the wrong stocks that are vegetating around 1% growth while other companies are growing faster and still pay dividends. In order to not fall in the “being paid to wait trap” I suggest you reassess the reason why you bought your stocks on a yearly basis. If the reasons are not there anymore, there is only two options left; get stuck in the trap or sell!
Here’s a few examples of stocks with no returns over the past 5 years.
#3 The High COP Dividend TrapThis third trap was brought up in a comment from Richard on “When Do You Sell When You Make Money?”. He mentioned that he keeps a few stocks paying very high dividends based on their cost of purchase (COP). If you do a good job with your stock selection, you will eventually get stocks paying 8% to 15% dividend yield based on your cost of purchase. In fact, the most courageous of you who bought Canadian Banks back in December 2008 are probably earning 25% dividend yield on theirCOP! This, unfortunately, is quite an exception.
More realistically, if you buy a company like Coca-Cola (KO) which historically doubles its dividend payout every 6.5 years, you will be earning a 7-8% yield in ten years. Then the catch is similar to the one found in the “being paid to wait” trap. Would you take your steady 8% dividend yield from a company that might only go down or would you restart with a fresh company paying a *small* 3% dividend yield but which is very promising? For the record, I’m not saying that KO should be sold because it’s going nowhere; I’m just taking the company as a good example.
In fact, when you look at the dividend aristocrats you have great examples of stocks that are continuously increasing their dividend payouts but don’t necessarily provide capital gains to investors. Here’s a quick list of underperforming aristocrat stocks over the past five years that are providing high COP dividend yield:
Cincinnati Financial Corp (CINF)
Pitney Bowes (PBI)
Sysco Corp (SYY)
Nucor Corp (NUE)
I totally understand that 8% yield is quite attractive. It’s actually the whole point of becoming a dividend investor; to seek dividend growth. You might have made a brilliant choice a few years ago, but it might not be the case today. Sometimes, you are better off selling your stock at profit than cashing your 8% dividend yield without real return.
Or you can also look at stocks that have a 3% dividend yield and a high 5 years dividend growth. I think that those 2 metrics combined could show some interesting picks:
It All Comes Down To Portfolio ManagementI guess the hardest part of investing is not to buy or sell a stock but to manage the portfolio as a whole. It’s as important to select the right stock as it is to sell it at the right time. This is why a good review of your portfolio and the review of fundamental characteristics of each stock are important to be made on a regular basis. Don’t become lazy because you are getting paid. You have the right to grow your portfolio too!
Stocks Discussed: PFE, KO, ERF, SYY, NUE, PFI,
Re 3 Dividend Traps You Must Avoid
Posted by: Adib Motiwala (IP Logged)
Date: August 9, 2012 12:20AM
Excellent article. Thanks for writing.
On the first point (high dividend yield trap), you rightly point out to look at the payout ratios to see if the dividend is sustainable. However, there could be businesses who do not need to retain earnings to run the business and so they can afford to pay out 80-100% of FCF out to shareholders. Typically, consumer businesses like KO, PEP or PM come to mind. PM has been paying out 100% of FCF in the form of buybacks and dividends (almost evenly splitting the two). So, the div yield is not high. less than 4% now. but, the total share holder return/yield is 8% or so. Also, I have seen some media stocks where the payout is 80-90%. And yes the yield could have gone up since the stock is down while dividend per share is constant. And if this high yield/payout is backed up by a net cash balance sheet (where they have 2-4 years of dividends sitting as cash on the balance sheet), I would argue those dividends are safer. Ofcourse, all depends on the business as well.
I do agree that dividend yield by itself should not be your investment criteria. You should look at many factors dividend growth, safety of dividend, balance sheet and payout ratio, capital intensity of the business and last but not the least valuation.
Your 2nd point and table is excellent. Often we see pitch for a stock for a stock with a high yield. No one mentions the 5 year total return on those stocks. Ofcourse, the stock not doing well for 5 years could well be a good value idea but you have to keep that in mind and know why the stock has not done for 5 years despite such a high yield.
Stocks Discussed: PFE, KO, ERF, SYY, NUE, PFI,