Dividend Trap: What Income Investors Need To Know

Printed on October twenty eighth, 2021 by Josh Arnold

Dividend traders have a lot alternative relating to what shares to purchase to fulfill their wants. Relying upon these wants – whether or not it’s capital appreciation, dividend progress, dividend security, or excessive dividend shares – traders would do effectively to keep away from sure kinds of shares.

You possibly can obtain your full free checklist of all 92 securities with 5%+ yields (together with essential monetary metrics corresponding to dividend yield and payout ratio) by clicking on the hyperlink beneath:

Whereas many excessive dividend shares are sound long-term investments, traders must be looking out for dividend traps.

These are shares which have dividends which can be too good to be true, and are unsustainable for one cause or one other.

A dividend reduce or suspension is among the many worst outcomes for earnings traders. Not solely does a dividend reduce lead to much less dividend earnings, however additionally it is sometimes accompanied by a steep decline within the share worth.

Because of this, traders ought to do as a lot analysis earlier than shopping for a inventory, to keep away from shopping for a dividend entice.

On this article, we’ll delve into what a dividend entice is, determine a future dividend entice, and an instance of 1 that really occurred.

What Makes A Dividend Entice?

A dividend entice is fairly easy; it’s a inventory that has a payout that’s unsustainable. This may be for a wide range of causes, together with excessive payout ratios, earnings contraction making much less money obtainable for dividends, or monetary burdens corresponding to huge debt.

Any of those elements, or a mixture of those elements, could cause a dividend to be unsustainable and ultimately, pressure the corporate to chop the payout.

Shares like this have a tendency to have uncharacteristically excessive dividend yields earlier than the reduce, as a result of traders are typically fairly good at pricing in dividend security. In different phrases, the share worth will virtually actually decline upfront of a dividend reduce as a result of the “writing is on the wall”, so to talk.

One warning signal with dividend traps is that the present yield strikes meaningfully larger, indicating the market sees some measure of uncertainty with the payout.

Basically, recognizing a dividend entice is the other of recognizing a terrific dividend inventory.

We search for shares to purchase which have cheap stability sheet leverage, sturdy aggressive benefits, strong earnings progress, and cheap payout ratios. These are the hallmarks of a terrific dividend inventory, so if you happen to see the other of those circumstances, the inventory might be a future dividend entice.

Now, let’s check out a high-profile dividend entice that occurred within the latest previous.

Basic Electrical (GE): A Case Examine

Our goal is industrial conglomerate Basic Electrical, a inventory that was very famously a part of the unique Dow Jones Industrial Common greater than a century in the past.

To say Basic Electrical was an essential dividend inventory for many individuals over the previous century can be a gross understatement, however even that couldn’t save Basic Electrical from shifting enterprise circumstances that brought about what has amounted to basically an elimination of its dividend.

The primary warning signal was years of declining earnings-per-share. If an organization’s earnings are in regular decline, the percentages of the corporate with the ability to proceed to pay its dividend – not to mention increase the dividend – diminish tremendously.

Basic Electrical posted decrease earnings in every year from 2017 to 2020, with 2020 outcomes being proven beneath.

Supply: Investor presentation, web page 4

Adjusted earnings-per-share got here in simply over breakeven for 2020, highlighting simply how far the corporate’s fortunes had fallen since incomes $1.49 per share simply 4 years prior.

We are able to see above the trigger for the earnings collapse was a mixture of weak income and plummeting revenue margins, each of that are sometimes current within the case of dividend traps.

This set of circumstances meant that the corporate’s obtainable money to pay the dividend continued to dwindle till it grew to become very clear the payout was merely unsustainable, and it was nearly eradicated.

Basic Electrical now pays a token one penny per-share every quarter because it tries to rebuild its enterprise, and earnings traders now have little cause to personal the inventory.

Now, let’s check out a inventory that could be a potential dividend entice right this moment.

A Potential Dividend Entice

A inventory that we see as a possible dividend entice right this moment, is enterprise improvement firm Oxford Sq. Capital (OXSQ). This can be a firm that invests in early and middle-stage firms by means of debt devices, borrowing from the capital markets and investing the proceeds at larger yields.

The enterprise mannequin is a typical one however carries with it important dangers, and we see Oxford Sq. as susceptible to being a dividend entice.

Oxford Sq. has reduce its dividend previously, which units a precedent that administration could also be keen to do it once more. We don’t suggest shares that reduce dividends for that reason, and Oxford Sq. did simply that in the summertime of 2020.

Nonetheless, regardless of the reduce, the corporate is susceptible to a different one.

The corporate’s funding earnings per-share, which is the BDC equal of earnings-per-share, has declined sharply within the final decade. It was 81 cents per share two years in the past, however we see lower than half that worth for 2021 estimates.

In apply, which means the corporate has lower than half the earnings obtainable to distribute to shareholders, which is what prompted the 2020 dividend reduce. Even with this diminished dividend, Oxford Sq. is in peril of needing to chop once more.

The present dividend of three.5 cents per share per 30 days means Oxford Sq. wants 48 cents per-share of funding earnings yearly to pay the dividend. We forecast simply 36 cents per share in funding earnings in 2021, down from 40 cents final yr.

That places Oxford Sq.’s present payout ratio at 117%, which is unsustainable, notably in gentle of how weak the corporate’s capacity to provide earnings progress has been in recent times.

Oxford Sq. has lots of the typical traits of a dividend entice. Its earnings are contracting at a swift price, it has no aggressive benefits, it has reduce the dividend earlier than, and its payout ratio is effectively over 100%.

These elements mix to create a scenario the place we don’t see the payout as secure. Regardless of its enormous dividend yield and month-to-month dividend payouts, we see Oxford Sq. Capital as a possible dividend entice.

Remaining Ideas

Whereas there are many nice dividend shares to select from, such because the Dividend Aristocrats, simply as essential as choosing nice shares is avoiding weak ones.

For traders trying to construct a dividend portfolio, avoiding dividend traps like Oxford Sq. Capital is essential, as a result of dividend shares that reduce their payouts are usually punished severely by traders through a decrease share worth.

We are able to use classes of the previous, corresponding to Basic Electrical, to determine future potential points, like Oxford Sq. Capital. In doing so, it could actually assist us keep away from these dividend traps and the harm they’ll do to our funding returns.

Different Dividend Lists

Together with the Dividend Aristocrats, the next lists have a lot of high quality dividend shares that aren’t more likely to be dividend traps:

• The Dividend Achievers Listing is comprised of greater than 350 shares with 10+ years of consecutive dividend will increase.
• The Dividend Kings Listing is much more unique than the Dividend Aristocrats. It’s comprised of 32 shares with 50+ years of consecutive dividend will increase.
• The Blue Chip Shares Listing: shares that qualify as Dividend Achievers, Dividend Aristocrats, and/or Dividend Kings