Part 3: How to avoid the ‘yield trap’
Sitting at home one day, you decide to flick through the paper and look at the section with all the share information on it. As you scroll down the columns, you start to notice that some of the stocks seem to be paying out an incredibly high yield.
Some of the companies you may be familiar with, others you might not. You know that you are on the hunt for income, and some of these stocks might just be able to help.
But buying a stock based purely on its most recent dividends can be a quick way to blow some capital. By looking at historical dividends and using them to calculate the current yield, you run the risk of falling into a ‘yield trap’.
A company might appear to have a really high yield because their price has crashed since the last dividend was paid. Dividends are historical, whilst the yield is calculated using the current share price. Effectively, you are looking at two different time frames.
A company may have paid out a larger dividend last year. But the market could be selling down the stock in anticipation of a smaller dividend this year. This can artificially inflate the yield until it becomes clear what their next dividend payment will be.
How does it work?
Let’s say a mining company paid out two dividends in the last 12 months as per the table below:
If the price of XYZ Mining Company was $5, the current yield will be 9%. Calculated by:
The two dividends (20c + 25c), divided by the share price ($5), multiplied by 100 (to make it a percentage) = 9%
Let’s also say that XYZ Mining Company is an iron ore producer. As the market hammers the iron ore price coming into 2015, XYZ’s share price rapidly comes down. It is now trading at $3 as investors rush to get out of the stock.
The lower share price now puts the yield at 15%. But the lower iron ore price will have a dramatic effect on its earnings. Management might decide they need to retain their cash. They may need to reduce or cut out the dividend entirely. The ‘indicated’ yield and the amount the company might actually pay out to its investors are two very different things.
A real life example
Similar to the above example, BC Iron [ASX: BCI] is an iron ore producer. Due to the huge impact of the large sell off in the ore price, they announced in their recent results that they would not pay out an interim dividend. The table below shows how much they paid out prior to this:
The dividend payments are also included in the graph below along the horizontal axis. You can see that in 2014, they paid out 17 cents and 15 cents in dividends. If you’d calculated the yield at the end of that year, it would have in close to 80%. But, clearly, these dividend payouts weren’t sustainable.
BC Iron [ASX: BCI] Share Price:
Cutting the interim dividend drops the yield straight away from around 80% down to 40% at the current price. But remember, this still includes the 15 cent payout in September last year. If the company decides to cut out its final dividend as well, then all of a sudden the yield drops to zero.
Although BC Iron is a dramatic example, the same can apply to any dividend paying stock. Even a slight reduction in a dividend can have a big effect on a stock.
Don’t get left holding the bag
A huge amount of money has flowed into the stock market over the last three or four years. Higher yields have attracted income hungry investors. It’s a game that has played out well for those that picked the right stocks.
But what are the risks now in just focussing solely on the yield?
One of the roles of management is to decide where best to allocate their cash profits. Do they re-invest it for future growth? Or do they give it to shareholders via dividends? That’s a problem the market is starting to run into. Investors are starting to expect an endless supply of bigger and bigger dividends.
This will be a key issue if the economy starts to slow. It will be a tough balance for companies to decide how much cash they keep, and how much they distribute to their shareholders. Investors will dump stocks that get it wrong.
Another thing you need to look at is the bigger picture. Slower growth in the overall economy will eventually flow through to lower earnings and profits for all but a few of the star companies on the ASX. This will mean less money for the companies to share around. And therefore smaller dividends and potentially lower yield for investors.
So, before buying a stock, you need to ask the following:
- Does the company’s dividend look sustainable?
- What’s the general health of the sector it operates in?
- What is the outlook for the overall economy?
By answering these three questions, you can better avoid falling into a ‘yield trap’ and buy into companies with better long term prospects of paying out cash to its shareholders.
Income Specialist, Daily Reckoning Australia