How to spot a dividend trap like a pro (and one of today's leading culprits)

If there’s one thing Aussie investors love, it’s equities yielding fully franked dividends.

And who can blame them. In 2022, 216 companies in the ASX300 paid out a collective $113.14 billion in dividends. That’s an enormous pot of honey, one that retirees in particular rely on.

What's more, Aussie companies like distributing dividends as much as investors like receiving them. As the below chart shows, Australia's payout ratio is almost double that in the US and global markets. 

Source: S&P Dow Jones

But dividends yields, viewed in isolation, can be misleading. Hence the term, “dividend trap.”

In the latest episode of The Rules of Investing, Dr Don Hamson discussed what a dividend trap is and the red flags he employs to identify them. He also names a well-known company whose dividends don't stack up right now. Read on for a summary. 

Beware of trap doors

Investors can get in trouble chasing stocks with high dividend yields. Yields only make sense in the context of the stock price they're based on.  

The dividend yield is calculated by simply dividing the annual yield per share by the current stock price.   

So the dividend per share remains the same, while the stock price falls, then the yield will go up. And vice versa.

“The easiest way for a stock to become a very high yield stock is for the current price to be depressed,” says Hamson. “[The] current price has fallen way out of bed compared to where it was 12 months ago or two years ago.”

“If you look at just the dividend side you're gonna say 'Great, it's fantastic.' But if you've been holding that stock and the stock price is halved, so actually your total return is rubbish.” 

Look to earnings

Dividends are ultimately a function of earnings. In the long run, if you don't earn anything, you can't pay a dividend. But the short-term can be a different story. 

"Some companies may have retained earnings and be able to maintain that dividend, but if their earnings are depressed for the longer term, they are eventually going to have to cut that dividend."

"If they're just holding it extremely high, in the short term paying out more than their earning, that's a bad signal."

Companies can keep the music playing for a time but, at a certain point, the music will stop.

"If they're paying out more than they're earning, then their dividends are unsustainable and eventually, unless their earnings bounce back, eventually they will have to cut that dividend."

"So it's a bit of false hope for companies, if they try and maintain an abnormally high dividend, just to try and keep the share price up."

Long story short, if you see a company paying out the overwhelming majority of their earnings in dividends, let alone more, look for the exit. 

Today's traps

Hamson points to Magellan Financial Group (ASX: MFG) as a prime example of a dividend trap in today's market. Currently, Magellan is yielding 13.10%.  

Magellan 12-month price chart (Source: Market Index)

"Magellan was trading on something like a 20% cash yield and about a 25% gross yield."

"... but the share price over the last couple years absolutely collapsed. And I said, that's telling you something. And sure enough, in February when it announced its results, it cut its dividend. It cut us dividend in August last year as well. And I suspect it will cut a dividend again in August this year."

Hamson also flagged consumer discretionary as a sector facing headwinds as growth slows and disposable incomes diminish. But the impact on earnings, and in turn dividend sustainability, is still to be seen. 

"Those stocks have had fantastic earnings for the last few years, but it's getting much tougher."

"It's not very easy to say JB HiFi (ASX: JBH) or Harvey Norman (ASX: HVN) are a buy or sell because they're actually priced for big falls in earnings. If the falls aren't as much as people see and their dividends do hold up because the earnings hold up, then they'll be good investments."

This article was first published for Livewire Markets on Tuesday, 20 June 2023.