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:
- 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.
- 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.
- 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.
- 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.
- 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.
