A dividend trap will do two things in your portfolio. First, it will leave you with the impression of safety. The market goes crazy, it creates confusion, it goes up and down, and then you feel safe because you receive your dividend every month or every quarter. That dividend is a high yield and produce a lot of income from your capital. It feels good, right? You feel smart.
But the second thing the dividend trap will do is to destroy that capital. Management at one point or another will ultimately announce a dividend cut and will call one of my favorite expressions: “Oh, we’re looking for financial flexibility, we’re going to improve our balance sheet.” Yada yada.
To make things simple, I’ve decided to split this article in two. Today, we will define what is a dividend trap. Next time, I will share with you my three favorite techniques to avoid them.
What is a Dividend Trap?
Basically, a dividend trap is a company offering a good yield. By good yield, I mean something probably higher than 5%, something that you can picture yourself retiring on. It’s easy to think, “I amass a million dollar, I wanna invest it at 6%-7%, making $60,000, $70,000 a year”.
In such cases, you’re likely to go after higher yielding stocks to ensure your income. Feels great, but it’s not gonna work. Behind that high yield, there is a company with a flawed business model, with a management that doesn’t know what to do with their money besides giving it away to shareholders. They are unable to make it grow.
Sooner or later, especially during a recession as we’re living right now, they announce a dividend cut. You wake up one morning, your income has been cut by half and your capital is not one million anymore, it’s like $700,000. You lose 30% on your investment, your income source is cut by 50% and you just don’t know what to do.
This is a dividend trap. Bad business with promises of paying you a generous dividend.
There’s No Free Lunches in Finance
Over the past four months, we have probably seen a record number of dividend cuts in the history of dividend growth investing. As most media are quick to jump the gun and blame the covid-19, the situation is far from being so simple. In fact, many companies would have cut their dividend sooner or later anyway.
For example, the Hertz (HTZ) financial difficulties were known well before the covid-19 hit the economy. The company never adjusted to the new reality in its industry: customers were able to shop for the best price and best vehicles within seconds online. HTZ entered a bidding war to acquire Dollar Thrifty in 2012 and this was the beginning of the end. The company overpaid for the acquisition, the integration was a nightmare, and Hertz hid behind their good name to find ways to boost their credit standing. They literally maxed out all their “credit cards” and then the virus struck. Hertz was literally hiding their difficulties in plain sight for years, but investors did not choose to see the obvious.
Between 2010 and early 2020, the market had become complacent. The economy was growing steadily, interest rates remained low and the appetite for new debt was high. Many mediocre businesses jumped into investors’ fishnets and entered the boat. Many income seeking investors were just happy to gather 6%+ yielding stocks.
While we recently were struck by a massive amount of dividend cuts, I believe we are not down and out yet. Far from it. The economy will eventually recover, and the market will get back into its bullish mode. This could happen as soon as 2021 or possibly later depending on how the virus evolves over the coming 12 months. In the meantime, rest assured of one thing: there will be a ripple effect on the first wave of dividend cuts and bankruptcies.
One thing is for sure, we are all investing in the stock market to make money. I don’t know any investors who’s telling me, “Mike, I’m putting my money in the market just for the fun of it, and I hope to lose money.” So why in the world a company should be forced to offer a 5% yield and up? That is kind of like the trigger that there’s a red flag.
I’m not saying that all high yielders are bad investments, that’s totally not true. What I’m saying is, if you find a company you like and the yield is over 5%, there’s a red flag there. You should investigate and understand why it’s happening.
Stay tuned as next time we will cover a short and applicable list of actions you should take with your portfolio this summer to make sure you don’t suffer from additional cuts this fall.