How to avoid dividend traps

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

AGL Energy up to 13% gross dividend yield 

A great recent classic example of this was AGL (ASX: AGL). At the top left of the chart, you can see the stock price of AGL which falls strongly during the period. 

This chart is from 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. 

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 AGL's case because AGL's earnings were going down due to electricity margins coming down, wholesale electricity prices were dropping, and so AGL's earnings 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.

Maximise your income

The Plato Australian Shares Income Fund focuses on high income and total return. A big part of the strategy involves predicting dividend traps and avoiding them. Find out more about the fund here.