Avoiding Dividend Traps: Tips for Canadian Investors

These two Dividend ETFs from BMO have built-in screeners to sift out dividend traps.

| More on:
Double exposure of a businessman and stairs - Business Success Concept

Image source: Getty Images

Ask yourself: what kind of a dividend stock yields 8% and above? The answer is “probably a bad one.” Yes, the high income can be alluring, but it comes at a cost. Remember, there’s always some type of risk lurking behind a potential return, and you’re not always compensated fairly for it.

Dividend traps are essentially stocks that tempt investors with high dividend yields but later lead to significant losses in capital value. These traps can catch even the savviest investors off guard.

You invest in them for the appealing dividend, only to find yourself bagholding a stock that has plummeted in value, resulting in a substantial unrealized loss.

Avoiding such traps is key to maintaining a healthy and profitable investment portfolio. It’s not just about being attracted to high yields but understanding dividends’ sustainability and reliability.

Here’s how to steer clear of dividend traps step by step. Additionally, I’ll introduce two of my favourite dividend exchange-traded funds (ETFs) that effectively screen out potential traps, focusing instead on quality dividend stocks.

How to avoid yield traps

So, you’ve identified a dividend stock with an appealing yield you might like. Great! But before you buy, it’s important to perform a thorough check to ensure it’s not a yield trap. Here’s my five-point, step-by-step guide on key metrics to evaluate:

  1. Payout ratio: This is the percentage of earnings paid to shareholders in dividends. It’s a crucial indicator of dividend sustainability. A payout ratio that’s too high (generally over 80%) can signal that the company might not be able to maintain its dividend payments, especially if earnings drop. Look for a balanced payout ratio that shows a company can comfortably cover its dividends without compromising its financial stability.
  2. Return on equity (ROE): ROE measures a company’s profitability by revealing how much profit it generates with the money shareholders have invested. A high ROE indicates efficient management and financial health, which supports ongoing and potentially growing dividend payments. Consistently high ROE is a positive sign when considering dividend stocks.
  3. Dividend growth: Assess both the rate of dividend growth and the consistency over the years. Stocks that have a history of steadily increasing their dividends, such as those qualifying as “Dividend Aristocrats” (five years in Canada), are often more reliable. A consistent track record of dividend growth suggests a commitment to returning value to shareholders and financial resilience.
  4. Free cash flow (FCF): Free cash flow is the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets. It’s a key indicator of a company’s ability to sustain and increase dividends. Strong and consistent FCF provides assurance that a company can continue paying dividends, even in less favourable economic conditions.
  5. Earnings growth: Finally, examine the company’s earnings growth. Consistent earnings growth can indicate a company’s potential for future dividend increases and financial health. On the contrary, stagnant or declining earnings can be a warning sign of potential trouble ahead, including the risk of dividend cuts.

Two ETFs that do it all for you

Is that too complicated or tedious? I get it. If you want to stay more hands-off, ETFs like BMO Canadian Dividend ETF (TSX:ZDV) and BMO US Dividend ETF (TSX:ZDY) can do all the hard work.

ZDV and ZDY use rules-based strategies to select Canadian or U.S. dividend stocks, respectively. Both ETFs check for three-year dividend-growth rate and payout sustainability via the five-year payout ratio to form a composite score. Then, the holdings are weighted by yield.

As of November 24, 2023, investors can expect an annualized distribution yield of 4.47% and 2.60% for ZDV and ZDY, respectively. As a bonus, both ETFs also pay monthly dividends.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Tony Dong has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

More on Dividend Stocks

analyze data
Dividend Stocks

2 Dividend Stocks I’d Buy if They Fall a Bit

Consider buying Brookfield Asset Management (TSX:BAM) and another top stock on a larger pullback.

Read more »

Payday ringed on a calendar
Dividend Stocks

TFSA Investors: 2 of the Best Monthly Dividend TSX Stocks to Buy Right Now

Create a monthly tax-free income stream in your TFSA by investing in these two TSX dividend stocks that pay investors…

Read more »

Dollar symbol and Canadian flag on keyboard
Dividend Stocks

3 Top Canadian Dividend Stocks to Buy Under $30

Given their stable cash flows and healthy dividend yields, these three dividend stocks are excellent additions to your portfolio.

Read more »

money cash dividends
Dividend Stocks

Beat the Dow Jones With This Cash-Gushing Dividend Stock

Here's why this high-dividend TSX stock should beat the Dow Jones index in 2024 and beyond.

Read more »

Pixelated acronym REIT made from cubes, mosaic pattern
Dividend Stocks

The Top Canadian REITs to Buy in February 2024

Are you looking to boost your income and buy some stocks at a bargain? Here are three top REITs that…

Read more »

calculate and analyze stock
Dividend Stocks

Better Buy in 2024: Canadian Utilities Stock vs. Enbridge Stock

Dividend stocks like Enbridge (TSX:ENB) and Canadian Utilities (TSX:CSU) are staples of Canadians' portfolios.

Read more »

Increasing yield
Dividend Stocks

2 No-Brainer High-Yield Dividend Stocks to Buy Right Now for Less Than $1,000

Got $1,000? Here are two no-brainer stocks to buy now at their lows and start getting immediate returns of $75.

Read more »

Gas pipelines
Dividend Stocks

Is Keyera a Buy After Its Solid Fourth-Quarter Earnings?

Given Keyera's solid quarterly performance and healthy growth prospects, I am bullish on it.

Read more »