How to identify dividend traps (and a compelling company that is actually growing its yield)

Ah, dividend traps. The Achilles' heel of any income investor's portfolio. These too-good-to-be-true dividend yields are often that, enticing - sure, but unsustainable. 

Over the past year, the yields of companies like Regal Investment Fund (ASX: RF1), Magellan Financial Group (ASX: MFG), and Fortescue Metals Group (ASX: FMG) have rocketed to persuading highs, but can these stocks continue to pay out sustainable yields in the future? 

According to Michael Maughan, portfolio manager of the Tyndall Australian Share Income Fund, the simple answer is no. He warns investors off using yield in isolation and notes that on its own, this measurement can be a dangerous indicator for finding value.  

So in this wire, he shares where investors can find sustainable yield this coming earnings season (and beyond), as well as one stock that will provide investors with the much-needed growing dividend yield they are searching for over the short and medium term. 

Note: This interview was recorded on Wednesday 27th July 2022. You can watch the video or read an edited transcript below.

Edited Transcript

Ally Selby: Hello, and welcome to another cracking expert insights video. I'm Ally Selby, and today I'm joined by Michael Maughan, the head of the Tyndall Australian Share Income strategy. Today, we're talking about dividends, where the traps are, and where you can find sustainable growth in the future. Thank you so much for joining me today, Michael, such a pleasure as always.

First off, I want to talk about some of the typical stocks in investor's portfolios - Telstra, the big four banks and the iron ore miners - they've really become staples in income investors' portfolios. Do you think these companies will continue to pay out sustainable dividends in the future?

Michael Maughan: When we go through that list, I think the miners have been the biggest part of the dividend pie over the last few years. The iron ore price is still above US$100 dollars. It's lower than it was, but when we look at it against history and where we think iron ore will be in the long-term, it is still very high. We expect the iron ore miners to be good cash flow generators and big payers going forward.

The banks are in a period where they do have a positive tailwind. There's not a lot of growth there, but they do have a positive tailwind in terms of margins because of rising rates.

The more exciting part of that group is Telstra (ASX: TLS). It's had a change in the short term to its core business and it's returned to growth. The mobile business is growing and the headwinds from the NBN are behind it. And over the medium term, it's probably one of the few companies we expect will have capital management and material returns to shareholders from asset sales. 

This is because Telstra has fixed infrastructure assets it's looking to sell. If you go back to when they sold their towers business, that was a return of over a billion dollars to shareholders. And the fixed assets are more than five times the size of that.

Ally Selby: We talked about some of the dividends that are growing and sustainable. Let's talk about some traps. Can you explain to our readers what a dividend trap is?

Michael Maughan: There are two types of dividend traps. There's the cyclical aspect and there's the structural aspect. The cyclical aspect is you have companies that are going through cycles, the miners are a classic example. In times when the iron ore price is high, and in times when it's lower. If you were to value that company on last year's earnings, when the iron ore price was US$220, that might not be the best benchmark to use upon which to value the company. And that came to bite. If you go back to a period like 2016 for the miners, that's a classic example of that.

On the structural side - if you think about discretionary retailers, for example, and value them without considering the fact that the world has changed with online retail, then you will be using the wrong benchmark to value them. It'd be the same as valuing a media stock without considering the fact that Google has completely changed the world when it comes to how people advertise.

So it's not that any of those examples are good or bad companies, it's just that last year's profits or any one year's profits are not the right benchmarks to use to value a company.

Ally Selby: Some of the highest yielding stocks in the market over the past year have actually underperformed the rest of the market, the likes of the Regal Investment Fund (ASX: RF1), Magellan Financial Group (ASX: MFG), and Fortescue Metals Group (ASX: FMG). Would you consider these to be dividend traps?

Michael Maughan: I think it's interesting because the fund managers are susceptible to both of those types of dividend traps. They're cyclical in that they're subject to markets going up and down. If you're to use the yield of a fund manager based on the peak of the market, then that would be the wrong number as would using the bottom of the market. But they're also subject to structurally specific aspects. If you think about flows, if you've had poor performance or you've got some brand issues and your flows are negative, last year's profits are not that relevant as a means of valuing a company, that's for sure.

Ally Selby: How about Fortescue?

Michael Maughan: Well, Fortescue falls into that same bucket with miners. Yes, I would definitely not use last year's yield as a way to value the company, because a yield in the high-teens is obviously too high. So if the market we're using that yield, then the stock would be much higher.

Ally Selby: To finish off the interview today, I'd love to know one piece of advice you have for income investors right now.

Michael Maughan: I think you've got to be very careful in using yield in isolation as a way to pick stocks. 

If you look historically, yield on its own isn't a great indicator of value. You need to combine it with some measure of value and some measure of quality to assess the sustainability of a dividend. 

We've got a team of 12, leveraging 250 years of combined experience to forecast forward instead of looking back. We're looking forward and asking what cash flows are a company going to generate. And that's going to drive the dividends.

Ally Selby: Thank you so much for your time today, Michael, it's been an absolute pleasure.

Michael Maughan: Thanks, Ally.

Ally Selby: If you enjoyed that video, remember to give it a like and subscribe to our YouTube channel. We're adding new content every week.

A front-row seat to income and growth

Michael and the team at Tyndall AM invest in income-generating stocks to put money in your pocket. To learn more, visit their website here.

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Tyndall Australian Share Income Fund

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