All things being equal, higher dividend yields are better. However, many dividend stocks ' high yields are signs of trouble.
In this episode of Industry Focus: Financials , host Michael Douglass and Fool.com contributor Matt Frankel discuss what a yield trap is, how to detect one, and a few examples of stocks that have characteristics of yield traps.
A full transcript follows the video.
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This video was recorded on April 30, 2018.
Michael Douglass: Welcome to Industry Focus , the podcast that dives into a different sector of the stock market every day. It's Monday, April 30th. This is the Financials show, and we're taking a break from some of our usual coverage to talk about dividend yield traps. I'm your host, Michael Douglass, and I'm joined by Matt Frankel. Matt, great to have you back!
Matt Frankel: Always good to be here!
Douglass: Fantastic! So, folks, think of this as a bit of a follow-up from Vince Shen's Consumer Goods show last Tuesday, April 24th. It was a great episode where he and fool.com contributor Asit Sharma talked through stock screening tools and how they can help you source new stock ideas. If you haven't listened to it, I highly recommend it. It was really thoughtful, really informative, a lot of good action-oriented stuff that you can do. Really a great set of resources for investors, and I thought they did a great job of really putting that all together.
One of the first things that I see plenty of people do when they start screening for stocks or funds is to look for high dividend yields. And it kind of makes sense, in theory. A dividend is this income that theoretically, hopefully, you can count on, so, a lot of new investors like immediately looking for that sort of thing.
Frankel: Sure. All things being equal, of course you want a higher dividend yield. Just to give you a personal example, when I was trying to decide between AT&T (NYSE: T) and Verizon (NYSE: VZ) for an investment, the fact that AT&T had a higher yield when pretty much the rest of the business I valued the same way, give or take, played a big role in my decision to choose AT&T over Verizon for my own portfolio. So, all things being equal, higher dividend yields are obviously better. You want dividends to compound over time. A higher starting payment will allow you to compound more over time. But, there's a little problem behind that, which we'll get into in just a second.
Douglass: Yeah, and that's that really high dividend yields -- now, how do we define that? There's nuance there, and we'll get into that a little bit further down the line. But, really high dividend yields sometimes signal trouble. There's this thing that happens to a lot of new investors, and it actually happened to me, where folks will see this really high yield and say, "OK, great, this is the business. It's a 20% yield, how can I lose money?" This happened to me. Trust me, I lost 99.9% of my investment. Best $200 I ever lost, by the way, or I have ever spent on just about anything, because I learned so much about how not to invest off that. I think you have to first learn how not to invest before you figure out how to invest .
But, we call these yield traps. It's essentially a stock that has a massive dividend and people buy it because it looks like such a juicy dividend. The problem is, the business itself is actually fundamentally in a shaky spot, and there's a lot more risk than you usually associate with a dividend stock. We call that a yield trap.
Frankel: A yield trap, like Michael said, either there's something wrong with the business -- it could be a declining market. It could be that they're using a ton of leverage. There's a bunch of different reasons which we'll get into more specifically in a minute. But basically, a dividend yield trap is a case of, if it's too good to be true, it probably is. [laughs] And there are a lot of high-yielding stocks that should immediately set off red flags in your head as an investor.
Douglass: Right. I received two listeners questions in the last week and a half about dividend funds that I viewed as yield traps. I have no idea if that was tied to a screen that they'd done as a result of Vince and Asit's fantastic episode, but we figured this was a great opportunity to talk about yield traps -- it was kind of on my mind anyway -- and really talk through what that looks like, on the general idea that, where two are emailing, perhaps many of the other dozens of our podcast listeners are thinking about some of this and maybe have already performed some screens and found some really high-yielding dividend stocks.
On today's episode, we're going to talk through dividend yield traps conceptually, and then go through some examples of stocks that Matt and I view as potential dividend yield traps. If you're interested in learning more about this concept and how to avoid them, we've put together some great resources for you: a dividend yield trap checklist based off today's episode, and an in-depth article that further explores the concepts we're covering today. If you want those, send us an email at email@example.com and we'll be happy to send those along. This is basically the longest wind-up ever, everyone, and I'm sorry about that, but I just thought that the story behind this was really interesting.
With all that in mind, we see five indicators that a stock may be a dividend yield trap. And let me be clear here, "may" is the operative term. There is, unfortunately, no magic formula that guarantees a stock is a yield trap. You'll really only know after the fact, basically, if they cut the dividend or the company goes out of business, or even something less terrible happens than that, but just in general, the company doesn't really move forward and is really struggling with the business.
For me, when I'm looking at stocks, when I'm screening for stocks and when I'm approaching stocks, if a stock I'm evaluating checks at least two of the five boxes that we're going to talk about, I tend to get a little bit nervous. That's when I tend to think, "OK, my risk is pretty high. Even if my returns are OK, I'm looking at a relatively high risk-adjusted return," and as an investor, I want to avoid that. Generally speaking, I'm only willing to take on risk when I'm getting a really impressive potential return. Of course, your mileage may vary, and no one can predict the future. But that's personally where I lean.
Frankel: I like the No. 2 that you just mentioned, two of the five boxes. Specifically, as you'll see you in a minute when we go through these, any one of them doesn't necessarily indicate trouble. I already mentioned leverage briefly earlier. There are companies that take on a lot of debt for very legitimate reasons. So, that in itself wouldn't be a cause for concern. Obviously, if a company checks all five of the boxes, I would run in the other direction. [laughs]
Douglass: [laughs] Quickly.
Frankel: But, I'd say, two or more definitely warrants a closer look and some caution. Approach with caution if there's two or more.
Douglass: Yeah. So, with all of that, let's talk about the criteria. The first one is the one that probably attracted you to the company in the first place -- an unusually high dividend yield. To be clear here, unusually high dividend yield really depends, to some extent, on the sector that we're talking about. A real estate investment trust or REIT, they tend to have higher dividend yields because they're actually required to pay out almost all of their otherwise-taxable earnings as dividends. That's just how REITs are structured. MLPs tend to have really high dividend yields just as a sector. Tech companies tend to have relatively low dividend yields. So, while a 5% or 6% dividend yield in a REIT isn't necessarily outside the realm of normal, in a tech company, it might be. A bank that's yielding 7-8%, that immediately causes this yellow flag. Again, it's a potential issue.
Frankel: Yeah. It's all about comparing the company with its peers. I mentioned earlier AT&T and Verizon. That's a great way to compare two stocks that are very similar business models to see if one has an unusually high yield. Even within sectors, there are fast-growing tech stocks and then there are the mature companies like, say, Microsoft . So, it pays to look at a company in relation to its peer group, I would say, to see if it has an unusually high yield or not, before you move on and check that box.
Douglass: Right. And one thing that we'll be sharing in the write-up is some general thoughts, within financials, as to what a pretty typical dividend yield for each of the main financials sectors, at least, looks like, just so you get that feel for, "OK, 6%, that seems like a lot." Or, maybe it's not, in this case. So, again, to reiterate one more time -- this will be the last time I say it, I promise -- no one criterion is necessarily enough for concern. It's really once we get to two.
The second one, as you talked about earlier, Matt, is excessive debt.
Frankel: Yeah. The general idea is, the more debt a company has, the more likely it is to run into trouble when things don't go its way. There's an old saying that a company with no debt can never go bankrupt. Not entirely accurate, but it's pretty effective. The way I like to look at this is, look at a company's debt-to-equity ratio, which, you can easily find both of those numbers right on its balance sheet, outstanding debt and shareholders' equity. And, compare that not just with itself to see if it seems like it has a high level of debt, but compare it with the dividend yield with other companies in its industry to see if something seems out of whack. Telecom companies like AT&T and Verizon tend to take on more debt than tech companies, which tend to have very little debt, for the most part.
Douglass: Right. REITs tend to take on a lot more debt than, say, restaurants.
Frankel: Right. This is not an apples-to-apples comparison. Just because a company has, say, higher than a 1:1 debt-to-equity ratio doesn't necessarily mean that it's a big red flag. But, if a company has a debt-to-equity ratio of, say, 3:1 and the rest of the companies in its sector are in the 1:2 range, then it might be a cause for alarm.
Douglass: Right. Keep in mind, as well, we're in financials. This is a pretty levered area in general. Banks, REITs, a lot of these companies do tend to take on a fair amount of debt. So, that nuance is really important. Just because there's a fair amount of debt, doesn't necessarily mean anything bad if that's how things operate. Again, it's all about that nuance and that story.
No. 3: payout ratio.
Frankel: Right. There's a couple of ways you can calculate this, depending on what sector you're talking about. Payout ratio, in its simplest form, is just the ratio of a company's dividends paid per year to its earnings per year. So, if a company paid out $0.50 in dividends last year and earned $1.00 per share, its payout ratio would be 50%.
Payout ratios above 100% are particularly alarming. The one area where that wouldn't apply to is REITs, companies that have to pay out a lot of their earnings and have a lot of accounting things like depreciation that distort what they're actually making. In REITs case, actually, a lot of times, you'll see REITs with payout ratios just based on earnings of well over 100%. And not only is it OK, it's actually very sustainable, in some cases. With REITs, you want to use a metric called funds from operations or FFO for short. That's the REIT version of earnings that takes into account depreciation and things like that.
Douglass: Right. One of the other pieces is, sometimes a company buys another company. We've all probably been watching enough news to see that happening. And as a result, their earnings will be materially affected for a year. So, that payout ratio might spike well above earnings for a year. But, that was something that, in all likelihood, they planned for, they had some cash set aside for it, they didn't want to interrupt the dividend that year. But, in that case, it's useful to look back a couple of years and say, "OK, before company A bought company B, this one-year thing, what was the payout ratio?"
One of the other ways to look at payout ratio, by the way, is the cash dividend payout ratio, which is to look at operating cash flow minus capital expenses and compare that to the dividend payout. So, if they're paying out $0.50 per share in cash, and they have free cash flow of $1.00, then that's a 50% cash dividend payout ratio.
Frankel: Right. Earnings can be deceiving, is the takeaway there. Especially, like you said, in the case where one company buys another company. There are all kinds of accounting rules that are way too complex to get into in a 30-minute podcast that can really distort a company's earnings and make a dividend look too high when it's really not, or make a dividend look sustainable when it's really not. So, it's important to take a few different things into account, cash flow being one of them. If a company is bringing in more money than it's paying out, you might be OK.
Douglass: Right. And that actually segues us very nicely -- and, I will admit, on my part, unintentionally -- into our fourth potential flag, which is little or negative cash flow.
Frankel: Right. You don't want to see a company with negative cash flow after paying dividends, especially before paying dividends. All public companies issue three major financial statements -- the balance sheet, the income statement and the cash flow statement. The cash flow statement is readily available. So, you can see how a company is taking money in and paying money out. The dividend is one of the lines on the cash flow statement, so you can easily see how that factors into the equation. If a company's dividend exceeds its free cash flow, which is, as Michael said, the operating cash flow minus expenses, it could be a big red flag. That's the case in one of our examples coming up soon.
Douglass: Right. If a company is paying out cash, it should, generally speaking, be pulling in more cash than it's paying out. And, another piece to consider here is, think of this as a bit of a trade-off. Dividend stocks, generally speaking -- especially high-yielding dividend stocks, which is what we're really talking about as these potential yield traps -- tend not to be high-growth companies. If you're a high-growth company in a fast-growing part of the market, you should probably be, generally speaking, reinvesting your cash in R&D and expanding operations and marketing and things like that so that you can really grow that subscriber base or that customer base.
The dividend is usually there as kind of a, "Sorry we're not growing so much," sort of thing for income investors who are looking for something that doesn't have a ton of risk associated with it, and therefore, instead, they provide this predictable, hopefully, payout to investors. So, again, a company that's not generating a ton of cash and has a dividend, that raises some questions.
The fifth one -- it's funny, because we've talked about nuance with all of these, and they all come with nuance. The fifth one is the most nuanced of all, which is problems with the business.
Frankel: Yeah. Retail is a great example right now of a business that's having issues. If a business itself, if there's something wrong with it -- customer tastes are changing, people aren't buying your product anymore, your revenues have declined 50% over the past year, that's a big indication of a problem with the business. Dividends are a function of a stock's price. If a stock's price gets cut in half, its dividend yield will double. So, a lot of times, this is the reason you're seeing these excessive payouts.
A good thing I like to do, if I see a dividend that looks too good to be true, is look at a chart of the company's stock price over the past, say, two or three years, and see if there's a giant drop-off in price. That could be a really big indication that something is just wrong with the business itself.
Douglass: Right. Again, those five major criteria: unusually high dividend yield, excessive debt, high, seemingly unsustainable payout ratio, little or negative cash flow, and problems with the business.
Of course, we're not going to just keep this theoretical. We have three examples of companies that we wanted to vet as potential yield traps. Of course -- I'm going to say it again because I'm sure there are shareholders in these companies who are listening, some of whom are really excited about these companies. That's totally fine. We're not saying they're yield traps. What we're saying is that, by certain criteria, and we'll walk through those criteria, these are potential issues that shareholders or prospective shareholders should be aware of. And they're why you and I, Matt, personally, are staying away from them. But, of course, your mileage may vary. Your investment goals may vary. And that diversity of viewpoints and opinions is one of the things that we believe makes for a great investor community.
So, with all that in mind, let's talk through CenturyLink , ticker CTL. First step: yield unusually high.
Frankel: Yes. [laughs] Telecoms are generally on the higher end of the spectrum. AT&T and Verizon are, typically, depending on when you're looking, within the 4-6% range as far as yield. CenturyLink is over 11%. So, I would call that unusually high.
Douglass: Yeah. Double is one of those strawmen that you set up as, "Yeah, that's definitely there." And, excessive debt. Their debt-to-equity is 1.6:1. AT&T's, by comparison, just under 1.2:1. So, that's a pretty big difference. So, it definitely checks that box, too. Let's talk about payout ratio.
Frankel: CenturyLink made an acquisition recently, so their earnings are a little distorted, so we'll get to the cash flow in a minute. Even so, they pay out over 100% of earnings as dividends based on both the past 12 months and the next two years of analyst projections, which, as Michael said, an acquisition will distort your earnings for about a year. In this case, it's over 100% for a three-year period.
Douglass: Yeah, definitely concerning. Little or negative cash flow. They generated positive cash flow for the past two years, but they paid out dividends that were in excess of their free cash flow in 2017.
Frankel: Yeah. The free cash flow, which is the operating cash flow minus the expenses, the difference between those two was more than the dividend they paid out last year. So, that's concerning. That checks that box.
Douglass: Yeah. And, of course, problems with the business.
Frankel: Not necessarily. I don't see anything wrong with the telecom sector in general or CenturyLink's business. So, that would be four out of five in this case.
Douglass: Yeah, which is, again, for us, fairly concerning. Let's talk about Annaly Capital Management (NYSE: NLY) , that's ticker symbol NLY. Unusually high yield? Yes. It's 11.5% as of this morning, which is high.
Frankel: Yeah. No matter what industry you're talking about, a double-digit dividend yield is going to be high. Annaly is what you call a mortgage REIT, which is a real estate investment trust, but instead of buying properties, they invest in mortgage securities. Getting to the second point, excessive debt, the way mortgage REITs do this is, if you say you can borrow at 2% interest and buy a mortgage that pays 3%, that 1% difference is called the spread, which is your profit. Nobody wants a 1% return on their investments. So, these companies will borrow a lot of money in order to make big dividend yields like the 11.5% Annaly pays out.
In full disclosure, I've owned Annaly in the past. I don't right now, but I have in the past. And I'm not necessarily calling this a yield trap, as Michael said. But, there are certain risks involved with this stock, and this system can help you look a little deeper and realize what you're getting into before you buy one of these.
So, speaking of the excessive debt, Annaly's debt-to-equity ratio is almost 6:1, which is typical for a mortgage REIT, but is very high by any metric.
Douglass: Right. Then, of course, payout ratio. This is one of the areas where nuance matters. It's about 90% of funds from operations that Annaly is paying out. That's a little high for a real estate investment trust, but it's not really that high, so it doesn't actually check that box. Even though, you hear 90% of essentially the REIT version of earnings, and you think, "Well, that seems like a really high payout ratio," actually, for REITs, it's not necessarily. I've seen REITs that have really very successfully paid out dividends over a long time period right around that amount. So, it doesn't actually check that box. Even though, in pretty much any other sector, that would be a concern. Of course, cash flow is an issue.
Frankel: Yeah. Their cash flow statement shows negative cash flows for the past four quarters and for three out of the past five years. That's a concern. There's really no way around that. Three out of the past five years, they've paid out more money in total expenses than they've taken in.
Douglass: Yeah. And, of course, problems with the business. At the moment, there doesn't appear to be any. Rising interest rates are putting some pressure on real estate investment trusts in general. Because they are such debt-laden businesses, dependent on debt to grow, they struggle in a rising rate environment because they basically have to find increasingly high-yielding investments to then successfully be able to pocket that spread that Matt talked about earlier.
Of course, the other piece of this is, this is a company that's basically betting on mortgages. That can get a little dicey if, let's say, the housing market turns. And I'm not saying the housing market is going to turn any time soon, but at some point -- we were all around during the financial crisis, and we can see what kind of damage that can cause. So, there's a lot of risk attached to this dividend yield, even though right now, there aren't any really big problems with the business. So, Annaly checks three of the five boxes.
Let's talk about CBL & Associates Properties (NYSE: CBL) , that's ticker symbol, as you might guess, CBL. The yield is almost 20%.
Frankel: Yeah. So, that in itself should tell you to stay away.
Frankel: In this case, checking one of the boxes may actually be enough. But, let's go through the whole thing. CBL & Associates is an equity REIT, meaning that they actually own properties. They own shopping centers and malls, but not the really great kind. They own what are called B and C-level malls, which are the secondary, the older malls, things like that. Not the Galleria, these are the smaller malls.
They pay out almost 20% as of this morning. Just looking at their debt level, their debt-to-equity is 3.7:1. For REITs, you want to see closer to a 1:1, if that. So, they have an excessively high level of debt as of right now. Their payout ratio is not excessive just yet, but the problem with them is, they have declining earnings, first of all, and they have a lot of retailers in their malls that are in trouble. So, payout ratio is not excessive yet, but it's very possible it could be in the future.
Douglass: Yes, so, it makes sense for us to go ahead and jump forward to the fifth thing, problems with the business, right now. We'll come back to No. 4, which is little or negative cash flow, in a second. Problems with the business, yeah. Their malls and shopping centers have lots of exposure to troubled retailers, particularly Sears and JCPenney .
We've all heard, probably, about America's dying malls. I used to live near one. CBL seems to be highly exposed to this potentially major issue. This is one of the reasons why you're seeing earnings starting to decline, which again, makes that yield really concerning.
Cash flow is low, but it's not negative, so it doesn't actually check that box.
Frankel: And just like I said with the payout ratio, it's not negative, yet. It easily could be. Just to give you, this statistic scares me away from it, 60% of CBL's properties are anchored by either a Sears or JCPenney. [laughs] So, that alone should scare anyone who knows anything about the retail business away from investing in that company, especially if you think their long-term outlook is going to be nice.
Douglass: Right. So, CBL & Associates checks three of the five boxes, at least from our interpretation. So, that's our take on three potential dividend yield traps. As I noted earlier, if you want to learn more about that, we can send you that checklist with a little more nuance and writing about it, and of course, an in-depth article -- that Matt wrote, actually -- that further explores those concepts. Just send us an email at firstname.lastname@example.org , and we'll be happy to send that along.
Folks, that's it for this week's Financials show. Questions, comments, you can always reach us at email@example.com . As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is produced by Steve Broido. For Matt Frankel, I'm Michael Douglass. Thanks for listening and Fool on!
Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool's board of directors. LinkedIn is owned by Microsoft. Matthew Frankel owns shares of AT&T. Michael Douglass has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Verizon Communications. The Motley Fool has a disclosure policy .