Dividend.com describes that “a dividend value trap occurs when a very high dividend yield attracts investors to a potentially troubled company” but that “not all companies that pay a high dividend yield are in trouble.”
To avoid dividend traps, Canadian investors can check a number of things about the company, including the payout ratio, the earnings or cash flow history, and the debt levels. For illustration purposes, we’ll discuss a couple of dividend stocks that have cut their dividends this year.
Algonquin
Since 2019, Algonquin Power & Utilities (TSX: AQN) had trouble increasing its earnings. In fact, from 2018 to 2022, its adjusted earnings per share only rose roughly 4.5% (or about 1.1% per year). It also did not have the highest-quality balance sheet compared to its peers. So, during a period of rising interest rates since 2022, the company was faced with a relatively higher cost of capital, which further increased its interest expenses and weighed on earnings.
For example, Algonquin’s trailing 12-month interest expense rose north of US$122 million (up about 58%) compared to 2021. Currently, Algonquin maintains an S&P credit rating of BBB, which is still investment grade, but, again, not as comforting as some of its peers with higher credit ratings.
After a strategic review, Algonquin announced in August that it planned to sell its renewable power portfolio, which would turn it into a pure-play regulated utility that has the potential for valuation expansion, especially if it pays down its debt levels. Indeed, on a successful sale, management intends to use the proceeds for debt reduction and share repurchases, which can help drive a higher stock price.
After the dividend cut, its payout ratio is estimated to be more sustainable at 78% this year, which is more or less reasonable for a regulated utility. With its dividend yield of 7.6%, if it’s able to grow its adjusted earnings by about 5% going forward, it can deliver total returns of about 12-13% per year over the next five years, assuming no valuation expansion. That said, analysts think the stock is undervalued by about 35%, which can drive greater price appreciation down the road.
Perhaps a red flag, though, is that Algonquin has the opposite of retained earnings — accumulated deficit.
NorthWest Healthcare Properties REIT
Global healthcare real estate investment trust (REIT) NorthWest Healthcare Properties REIT (TSX:NWH.UN) just cut its cash distribution by 55% last month. A red flag is its lack of funds from operations (FFO) per unit growth. Additionally, it was caught in a rising interest rate environment. Its adjusted FFO per unit held up in 2021 but dropped by about 17% in 2022 in a higher inflation and higher rate environment.
In 2022, its adjusted FFO payout ratio also cut it too close at 95%. Investors can observe that its retained earnings dwindled from about $337 million a year ago to about $2.7 million in the last quarter.
At the recent quotation of $5.00 per unit, the REIT yields 7.2% with analysts calling a discount of close to 29% in the stock.
Investor takeaway
To be on the safe side, investors could avoid dividend traps by ignoring dividend stocks with yields that are more than two times that of the market. You can assume that the stock is higher risk if that’s the case. Today, the Canadian stock market yield is about 3.4%. So, if you see dividend yields north of 6.8%, it should raise a red flag.
It just so happens that both Algonquin and NorthWest Healthcare Properties continue to offer dividend yields beyond the 6.8% threshold. If you want to investigate further, also examine the company’s payout ratio, the earnings or cash flow history, retained earnings (or lack thereof), debt levels, and the dividend history.
