It might be tempting to buy dividend stocks with the highest yields, but not all dividend payers are safe.
Why it matters: Those big payouts could be signaling that a company’s fundamentals are cracking. Looming financial risks could wreak havoc on income-focused investors’ portfolios. But there are ways to spot dividend traps.
Morningstar Indexes strategist and columnist Dan Lefkovitz explains how to avoid the risks.
8 Questions on Dividend Income
- What are dividend traps, and under what conditions do they tend to develop?
- Dan Lefkovitz and his team published research on dividend traps just before Dow Chemical DOW cut its dividend in half over the summer. How does this research explain what happened with Dow?
- Other well-known brands have also slashed their dividend payouts since 2020. The list includes Shell SHEL, Walgreens, and Intel INTC. What warning signs were these companies flashing before their cuts?
- You have written about how income-focused investors can avoid dividend traps. Let’s start with step number one on how to spot them. What is the payout ratio, and what does it tell us about a company’s health?
- The second step focuses on a company’s durable competitive advantage or economic moat. Can you describe what that reveals?
- Your team weeds out dividend payers using a third step that relies on distance to default. How does that work, and what did you all find out?
- How can investors protect their dividend income from risks? Would portfolio diversification help?
- What’s the key takeaway to spot dividend traps?
Key Quote on Dividend Traps
A dividend trap is a stock that lures investors in with a big, fat payout that ends up being unsustainable. So, the dividend gets cut. And it’s not just a loss of income when a company eliminates, reduces, suspends its dividend payment. It’s usually also accompanied by a share price decline as well. Just a bad investor experience.
In terms of conditions, one way for a stock to have a high yield is for its share price to be depressed. That often happens when there are fundamental problems that are challenging the business. Investors have to be really careful. If you target the highest yields in the stock market, that can often lead you to troubled sectors, troubled industries, troubled companies.
Dan Lefkovitz, columnist and strategist, Morningstar Indexes
The Takeaway: Dan Lefkovitz says that there are do’s and don’ts when it comes to dividend investing. To help avoid dividend traps, investors should take dividend durability into account instead of hunting for the highest yields. Lefkovitz warns that investors also shouldn’t put too much stock in a company’s dividend history, and they shouldn’t let macro movements, like interest rate cuts, weigh too heavily on their assessment of a company’s potential. Keeping your eyes on forward-looking projections is key to finding a dividend that will last, explains Lefkovitz. And don’t forget about diversification.
More From Morningstar on Dividend Income
Despite Dow’s CFO stating in March this year that the company’s dividend was not at risk, investors saw a 50% dividend cut in July. While the announcement may have shocked investors, David Harrell said that this cut wasn’t a surprise. High yields can be a red flag, Harrell notes, and it’s important for income-focused investors to do their due diligence when trying to avoid dividend traps. Learn about what investors can take away from Dow’s dividend cut.
Although dividend investing is a popular strategy, Amy Arnott says that investors can still have blind spots. Do you think that dividend stocks are better stocks? How do they hold up in a recession? Whether you’re planning to dive into dividend investing or are already off into the deep end, make sure you know the answers to some common questions from Arnott’s deep dive into the seven things investors may not know about dividends.
Markets Brief moment: Both healthcare and consumer defensive sectors are lagging the broader stock market this year, but for different reasons.
Dan Kemp, chief research and investment officer at Morningstar Investment Management Europe, explored what’s behind it in this week’s Markets Brief column. He says consumer defensive stocks are falling from high valuations, while healthcare stocks are facing significant headwinds like politics and earnings growth. He reminds investors that’s why it’s important to understand not only what you own in your portfolio, but why you own it as well.
In next week’s Markets Brief, Kemp will examine what the latest data from the Federal Reserve’s preferred inflation tracker means for the near term.
Read Kemp’s perspective on the biggest headlines in the Markets Brief on Morningstar.com on Mondays.
Jess Bebel, an associate multimedia editor at Morningstar, contributed to this article.
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