Beware of yield traps

With interest rates are at record lows, investors may be tempted to chase high dividend-yielding stocks to replenish lost income in their portfolios. However, chasing dividend yields can be a dangerous strategy. Equites can trap investors into a false belief that high yields can cushion the total return from price correction.

We have written before about how to identify dividend yield traps. To recap:

1. Peak earnings

Dividends are paid out as a proportion of earnings and when earnings are under pressure dividends typically follow. Hence, investors must be wary when earnings are peaking. For example, from 2017 to 2019 Telstra had to significantly rebase its dividend from 31 cps to 13 cps because of the permanent loss in fixed line earnings to the National Broadband Network.

2. Weak balance sheet

Debt holders get priority to cashflows before equity holders. When it comes to corporate survival, management must pay interest to debt holders first before paying dividends to equity holders. During times of crisis dividends are cut first to preserve the balance sheet, as we recently witnessed during the COVID crash in 2020.

3. Excessively high dividend payout ratio

The higher the payout ratio (dividends as a proportion of earnings), the greater the likelihood of a dividend cut if earnings decline. In 2015, BHP had a 200% payout ratio and had to borrow from its balance sheet to sustain its dividend. Clearly, it was not sustainable which led to the company cutting its dividend and restructuring its progressive dividend policy to a payout ratio policy.

While weakness in any one of these metrics may not lead to a dividend cut, the more a company exhibits these characteristics, the greater the likelihood of a cut. Based on Vertium’s analysis there were a few yield traps identified over the last few months.

In searching for yield, the iron ore miners (BHP, RIO and Fortescue Metals) have been consistently offering high yields in the last couple of years. Their recent dividend yields were so high that 3 stocks accounted for about a third of the ASX100’s dividend yield.

Source: FactSet, Vertium

Hence, there was much anticipation from yield hungry investors leading up to the August reporting season as the iron ore stocks were about to pay out record dividends. They didn’t disappoint. They paid gargantuan dividends never seen before in their corporate history.

Source: Iress

However, the euphoria on the enormous dividend was short-lived. While dividend payments were large they were totally wiped out by the collapse of their share prices. It was like picking up pennies and getting hit by the proverbial steamroller.

Source: Iress

While the iron ore miners have excellent balance sheets and sustainable payout ratios they were yield traps because of their peak earnings, driven by the extremely high iron ore price. For instance, BHP’s earnings closely track the boom-bust cycle of the iron ore price. In recent months its earnings followed the iron ore price and has just crested over its peak.

Source: FactSet, Vertium

In fact, it takes about 3 months for consensus to mark to market earnings based on the prevailing iron ore price. Given this lag, consensus forecasts have further to go in revising down BHP’s earnings and dividends will certainly follow. It’s highly likely investors will not see the same level of dividends paid by the iron ore miners for at least another decade.

In conclusion, dividends are an essential component of investment returns but chasing yield can be a very dangerous investment strategy. At Vertium we are constantly on the look-out for yield traps with our lens sharply focused on peak earnings, weak balance sheets and high dividend payout ratios. Avoiding yield traps helps mitigate risk while generating a reasonable return from our investments.