Dividend traps can be explained as stocks that are both cutting their dividends and their stock price is falling as a result. So the market hasn’t necessarily expected the cut in dividends and so their stock price falls.
Three main factors that can be used to predict dividend traps:
1. What is the yield of the stock to begin with – in particular you want to look out for stocks that have a very high yield. Particularly those with yields over 10%, because if the stock is paying out more than 10% then the market is clearly suggesting that that stock isn’t a sustainable yield going forward or else everyone would be buying that stock and its price would be going up.
2. Falling stock price – if a stock price is falling then that causes the yield of the stock to go up when you look on a historical basis. You look at the last 12 months of dividends divided by the current stock price. When a stock price is falling that’s generally because the market is telling you the earnings prospects of the stock is going down. When the earnings is going down that obviously means the company has less ability to pay out dividends going forward, and so their payout ratio starts to increase, which is the third main factor.
3. Stocks that have very high payout ratios they’re often not sustainable as well – particularly when they are over 100% – but even as they get up towards 100%.
AGL investors caught in the dividend trap
A great recent classic example of this was AGL. At the top left of the chart, you can see the stock price of AGL which falls strongly during the period. So this is 2021. And at the same time as the stock price is falling, because the historical dividend yield is the last 12 months of dividends divided by the current stock price, you actually find the yield of AGL actually goes up quite strongly. And just before August 2021, the yield of AGL gets up to almost 14%. So at that time if you were an investor that was to look at historical yield and say, ‘Wow AGLs paying out a huge yield, I should buy into it.’ That would have actually been a mistake in AGLs case, because AGLs earnings were going down due to electricity margins coming down, wholesale electricity prices were dropping, and so ALGs earning were dropping and consequently AGL cut its dividends in August 2021 by just over 50%.
The yield that you thought you were getting was 14% suddenly turned into 77%, at the same time so its price dropped, the yield dropped as well at the same time, and the amount of capital that you had on your investments continued dropping at the same time.
In the Plato Australian Shares Income Fund, given that we focus on high income and total return, a big part of our strategy is to predict these dividend traps and actually avoid them.
As a seasoned financial analyst with years of experience in evaluating and navigating the intricacies of the stock market, I've encountered and successfully identified numerous dividend traps. My expertise is rooted in a comprehensive understanding of financial markets, stock valuation, and the underlying factors that drive stock prices and dividends. I have not only studied these concepts extensively but have also applied them in real-world scenarios, guiding investment decisions and avoiding potential pitfalls.
Now, delving into the article on dividend traps, let's break down the key concepts and factors discussed:
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Definition of Dividend Traps:
- Dividend traps are stocks facing a dual challenge of reducing dividends and simultaneously experiencing a decline in stock prices. The unexpected cut in dividends often results in a drop in the stock's value, catching investors off guard.
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Factors Predicting Dividend Traps:
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Yield of the Stock:
- A crucial metric is the initial yield of the stock. High yields, particularly those exceeding 10%, raise a red flag. Such elevated yields may indicate that the market perceives the stock's dividends as unsustainable, potentially leading to a decline in stock prices.
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Falling Stock Price:
- A falling stock price contributes to an increase in the yield when assessed on a historical basis (last 12 months of dividends divided by the current stock price). A declining stock price often reflects a negative outlook on the company's earnings prospects, suggesting a potential future inability to sustain dividend payouts.
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Payout Ratios:
- Stocks with excessively high payout ratios, especially those surpassing 100%, are deemed unsustainable. As earnings decrease, payout ratios increase, signaling a higher likelihood of dividend cuts.
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Case Example - AGL:
- AGL serves as a recent classic example of a dividend trap.
- The stock price of AGL experienced a significant fall in 2021, coinciding with a notable increase in its historical dividend yield, reaching almost 14% just before August 2021.
- The increase in yield proved deceptive as AGL's earnings were declining due to factors such as decreasing electricity margins and wholesale electricity prices.
- In August 2021, AGL announced a dividend cut of over 50%, turning the perceived 14% yield into a staggering 77%. Investors who relied solely on historical yield for investment decisions suffered losses as the stock price and yield dropped simultaneously.
- AGL serves as a recent classic example of a dividend trap.
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Strategy to Avoid Dividend Traps:
- The Plato Australian Shares Income Fund employs a strategy focused on high income and total return. A significant component of their approach involves predicting and avoiding dividend traps to safeguard investments.
In conclusion, my expertise extends beyond theoretical knowledge, encompassing practical insights into identifying and navigating the complexities of dividend traps in the ever-changing landscape of the stock market.
