How to avoid yield traps – Part 1

As a dividend-focused investor I’m always on the lookout for high yield shares, whether that yield is high relative to the market average or high relative to the company’s peers. However, as most yield-seeking investors soon discover, high yield stocks do not always deliver the yield you were hoping for. That’s because dividends can be cut or even completely suspended, and the higher the historic or forecast yield the more likely that is to happen. This is the dreaded yield trap, where investors are lured in by an attractive yield and then stung with a capital loss when the dividend is cut.

Like you, I want to avoid this fate wherever possible and so over the years I’ve built up a series of tests which every potential investment must pass before I’ll invest so much as a penny. These tests do not have any magical power to spot yield traps with 100% accuracy, but I do think companies that can pass these tests are far less likely to cut or suspend their dividends than those that fail to pass them.

A two phase approach: First quantitative, then qualitative

My approach to weeding out yield traps is twofold. First, I focus on a company’s financial numbers, looking for a range of features including: 1) A ten-year unbroken record of dividend payments; 2) a long history of relatively consistent revenue, earnings and dividend growth; 3) high rates of profitability (return on capital employed); and 4) small debt and pension obligations. These are simple quantitative measures that I can use to rule a company out if, for example, its total borrowings are more than five times its five-year average profits. You can find out more about these quantitative tests in previous Dividend Hunter articles….

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