Tony started investing during the 2017 marijuana stock bubble. After incurring some hilarious losses on various poor stock picks, he now adheres to Bogleheads-style passive investing strategies using index ETFs. Tony graduated in 2023 from Columbia University with a Master's degree in risk management. His investing qualifications include the Certified ETF Advisor (CETF®) designation from The ETF Institute, the Canadian Securities Institute's Canadian Securities and Equity Trading & Sales course(s), Franklin Templeton's Canadian ETF Proficiency course, Bloomberg Market Concepts, CFA Investment Foundations, and McGill University's Personal Finance Essentials. His work has also appeared in U.S. News & World Report, USA Today, NYSE ETF Central, NASDAQ Fundinsight, Cboe ETF Market, TheStreet, and Benzinga.
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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.
Be wary of a company that is paying out more in dividends than its net income. Over the long-term, the company can't pay out more than it makes. Be sure to also monitor fundamental performance.
The objective of the Dividend Growth strategy is to earn dependable dividend income with the potential for capital appreciation over time. The strategy will invest in high-quality Canadian companies which pay a dividend, have a history of growing dividends, and are publicly traded.
9 In other words, dividends are not guaranteed and are subject to macroeconomic and company-specific risks. Another downside to dividend-paying stocks is that companies that pay dividends are not usually high-growth leaders.
If you can sell it for as much as you paid, you have “captured” the dividend at no cost, other than the transaction costs. This strategy is executed by buying a stock just before the ex-dividend date, so that you will be a shareholder of record on the record date, and will receive the dividend.
To avoid falling into a value trap, investors should conduct thorough research beyond just financial ratios. Analyzing the company's competitive position, industry trends, management quality, growth prospects, and potential risks is essential.
Focus less on a company's dividend yield and more on its ability to consistently increase its dividend. Look for a company with a sound financial profile focused on a growing industry. Another aspect of a dividend investing strategy is to determine how you want to reinvest your dividends.
Since U.S. dividends are not paid from Canadian corporations, U.S. dividends do not qualify for the preferential Canadian dividend tax treatment. Foreign dividends, including U.S. dividends, are subject to tax at your marginal tax rate like interest income.
Different investor types tend to have a preference for how excess cash flow is returned. For example, investors who desire supplemental income, such as retirees, often prefer to receive dividends. A dividend is a real cash payment, which the investor can then use to spend however they wish.
Perhaps the greatest misperception about stock dividends is that they represent “free” or “extra” money, above and beyond the capital value of the shares you hold. This free-dividend fallacy leads investors to think of stocks as their cake, and dividends as an extra layer of frosting.
One of the biggest risks dividend investors encounter are what are called dividend traps. In general, a dividend value trap occurs when a very high dividend yield attracts investors to a potentially troubled company. To spot these traps, investors should look for he following warning signs: High payout ratios.
The dividend capture strategy offers continuous profit opportunities since there is at least one stock paying dividends almost every trading day. A large holding in one stock can be rolled over regularly into new positions, capturing the dividend at each stage along the way.
There are times when it makes better sense to take the cash instead of reinvesting dividends. These include when you are at or close to retirement and you need the money; when the stock or fund isn't performing well; when you want to diversify your portfolio; and when reinvesting unbalances your portfolio.
The Roth IRA five-year rule says you cannot withdraw earnings tax-free until it's been at least five years since you first contributed to a Roth IRA account. This five-year rule applies to everyone who contributes to a Roth IRA, whether they're 59 ½ or 105 years old.
Market Risk: One of the primary risks in dividend capture strategies is market risk. When investors hold stocks for a short period, they are exposed to market fluctuations that can impact the stock price. If the stock price declines significantly after the dividend is captured, the investor may face losses.
Creating a diversified portfolio, understanding the implications of dividend reinvestment plans (DRIPs) and being aware of tax efficiency are vital steps in maximizing dividend income while minimizing risks. The dream of living off dividends is attainable with the right financial planning and investment strategy.
Up to $3,000 in net losses can be used to offset your ordinary income (including income from dividends or interest). Note that you can also "carry forward" losses to future tax years.
Introduction: My name is Arielle Torp, I am a comfortable, kind, zealous, lovely, jolly, colorful, adventurous person who loves writing and wants to share my knowledge and understanding with you.
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