dividend traps

by Tony Loo
(NSW Australi)

Your explanations on dividend traps is very interesting.
We are considering to buy BOQ waiting patiently at $8.61 and we will accept the dividend 0.68 cut by 20% to 0.54 in future.
Basing my figure for education purpose the yield will be 6.27%.
Is this call a dividend trap.

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Jul 22, 2019
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by: Mike

Hello Tony,

This is a great question. I remember when I first started investing seeing some "dividend traps" that were yielding 10%. My thinking was that even if the dividend halved then I'd still get 5% which isn't too bad!

The fact is that this kind of investing has worked both ways for me. Sometimes the market is over reacting and the dividend cut is either small or doesn't happen. You pick up a bargain, the share price rallies, and you feel pretty smug. The great value investor of the 20th Century Walter Schloss has talked about how some of his best investments have come when a company has just cut its dividend as investors dump the stock without thinking about the price and the future dividends they'll get.

That said, I have had stocks with very high yields that have then gone on to scrap their dividend completely. In this case, the market was correct and I fell into the dividend trap. This is obviously frustrating to think about. From my experience, there are a couple of clues that may (but may not!) help you.

Firstly - how strong is the balance sheet? If the balance sheet is stretched and the company has a lot of debt to pay off then a dividend cut or elimination is far more likely to follow a drop in earnings. This is because it can be imperative for the company's survival to repay that debt. If the balance sheet is clean and there is little or no debt then, although a dividend cut may well follow a drop in earnings, there should be more flexibility to minimize the damage.

The second thing to think about is operational gearing/leverage. That means that a small drop in revenue can lead to a much larger drop in earnings. A company with large operational gearing is a company with large fixed costs (like most banks unfortunately) so the dividend cuts can be very severe in an adverse environment.

I cannot give advice on any individual stocks, so I can't help you with BOQ. Remember BOQ is a bank so by nature it is highly leveraged and will likely have high fixed costs. That said, the market can get overly gloomy in a tough environment and offer up some bargains.

I hope you at least have a couple of things to think about. Sometimes it can be worth diversifying amongst several of these types of investments as it only takes a couple to really come off to make a difference to your portfolio.

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