In most cases, dividend yield is an important consideration when evaluating a stock. In some instances, however, a dividend yield is meaningless due to the fact that it relies on a backward-looking metric. Even worse, an attractive yield can sometimes guide dividend investors astray, luring them to a company that is on the decline.
Yield Traps 101
All else being equal, investors generally prefer a stock with a higher dividend yield. The potential problem with high-yield stocks lies in that “all else” part. A high dividend yield from a troubled company may catch the attention of investors and distract them from the underlying fundamental issues.
High dividend yields usually do not last for long, but the manners in which they can return to “normal” levels are very different. The hope is that the price will rise as investors recognize the true value of future cash flows. But a yield trap occurs when the dividend on a high-yield stock is cut or eliminated, thereby lowering the yield. Investors who bought in to a stock with an 8 percent yield may suddenly find themselves holding a non-dividend stock with serious cash flow issues.
Recognizing the Bait
The bait of the yield trap is the juicy dividend yield, combined with the projections of individual investors. Buyers can be lured in by assuming that the current distributions will continue into the future. There is a tendency to view the dividend yield as a worst-case scenario; even if the stock price falls, investors can still count on the cash flow component of total return. When the dividend yield is north of 5 percent, that “worst-case scenario” begins to look pretty attractive.
The problem — when the steel trap snaps shut — occurs when the dividend payout is cut or even eliminated to conserve cash. Such a move frequently follows a big decline in stock price that causes dividend yields to climb.
Avon Products (AVP) serves as an instructive example of a dividend trap. In late 2012, the stock was trading at its lowest level in nearly two decades and the dividend yield had climbed to more than 6 percent.
An annual return of almost 7 percent in the form of dividends certainly seems to provide some value for investors. But, of course, that return was contingent upon the distribution remaining in place.
Shortly after the dividend yield hit 6.6 percent, Avon slashed its quarterly payout by almost 75 percent — from $0.23 to just $0.06.
All of a sudden, the dividend yield on the troubled company was below 2 percent. As of November 2015, those who bought in to the 6.6 percent yield have lost about 75 percent of their initial investment.
Positive Outcomes
Not all high dividend yields are traps of course; it’s possible that companies with high yields are able to sustain their distributions. In such cases, yields typically drop because the stock price rises — rewarding investors who snapped up the high yield.
Cincinnati Financial (CINF) saw its yield climb above 7 percent during the last recession as investors fled the financial sector. But the company actually increased its dividend in both 2008 and 2009, and has continued to do so ever since. That 7 percent yield isn’t around any longer, having declined steadily towards 3 percent as the stock price rose:
Though the CINF stock price showed extreme volatility in 2008 and 2009, a look at the company’s dividend payout didn’t indicate any of that uncertainty:
In fact, not all instances of dividend cuts or eliminations end poorly. Some companies are successful in conserving their cash to complete a turnaround process. Barnes and Noble (BKS) is perhaps the best example of this type of success story. The dividend yield topped 7 percent in early 2011, before plummeting as the company suspended its dividend completely:
But the BKS dividend has now returned several years later, and the share price is actually higher than it was at the time of the suspension:
In this case, investors chasing the 7 percent yield had the rug yanked out from under them — at least for a while. The elimination of the BKS dividend didn’t signal the end for the company, and it was eventually able to begin making distributions to shareholders again.
Evaluating Yield Traps
High-yield dividend stocks are naturally appealing to investors. The medium-term and long-term outcomes from holding these stocks, however, are far from homogeneous or even binary. Some high-yield dividend stocks have begun a slide into bankruptcy, while others are on the edge of a major turnaround. In most cases, the outcome lies somewhere in between; the company faces a challenging environment going forward, but remains in business.
Yield traps are obvious in hindsight, as are the tremendous opportunities. Evaluating a company in real-time is extremely challenging, but there are several financial metrics that can help investors spot a trap.
This article, Yield Traps: Everything Dividend Investors Need to Know, first appeared on Dividend Reference.