Dividend Traps and How to Avoid Them
What is a Dividend Trap?
A dividend trap is where the stock’s dividend and price decrease over time due to high payout ratios, high levels of debt, or the difference between profits and cash. These situations commonly produce an unsupported but attractive yield.
Why Are They so Attractive?
It is easy to be fooled by a high yield dividend, especially if you are new to investing. You see a nice yield and think to yourself, “I can make a lot of money with this.” In reality you won’t. If you are lucky you might make some money before the stock eventually crashed under its own weight. The old saying comes to mind that is very accurate to this situation, “If it is too good to be true, it probably is.”
How to Identify a Dividend Trap and The Risk of Falling Into One
Spotting a dividend trap is pretty easy. For new investors it could pose a challenge but that is why you are reading this article so I can help you. One red flag to watch out for is a dividend yield that is very attractive or high. If you have two companies and one yield is 3% and the other is 25%, which one of these will most likely cut its dividends in the future? The answer is the 25% one. This example here could indicate the company is struggling to maintain its financials so it offers an attractive yield to pull in more income. You see the yield, buy the stock and it helps them out in the short-term.
If you happened to fall into the trap you might face a variety of risks or you might already be feeling the pressure now. Having a dividend trap will usually mean you will face a fall in value and you’ll lose money off the stock, lose out on potential returns and if the company’s revenue is worse than advertised, you run the risk of losing everything for that stock.
A good example for this one is a company called Zim Integrated Shipping Services (ZIM). I bought this stock a year ago because I too fell victim to its high yield. I bought the stock at $17 to $20 range and before I knew it the company had financial troubles I did not see coming. Fast forward and the stock prices fell to $12. I lost a bit of money on this company but it was a valuable lesson for me.
Strategies to Avoid Dividend Traps
As an investor, you should focus on companies with a proven track record. You want to find stable and sustainable companies that offer a competitive dividend yield. The highest I would go is 7% but I would aim for 3%-4% range. This is sustainable and probably means the company is doing ok.
Research is key when it comes to picking a stock. Look up the company’s financials, their dividend history, payout history and any recent news related to them. This will help you pick the right ones. Dividend Kings and Aristocrats is a good list that can help you find quality companies.
