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Warning: 20% of companies are dividend traps! Here’s how to avoid them

Ever look at a company and think the dividend yields appear just a little far-fetched? You might not be as paranoid as you think. Shocking new research reveals there are literally hundreds of stocks waiting to trip you up.

According to Henderson International Income Trust (HINT), almost a fifth (19% to be exact) of all companies can be described as classic dividend traps, i.e. those “where the yield is just too good to be true compared to similar companies or to the wider market.”

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These traps tend to yield on average 5.7%, the financial giant advised, more than double the current 2.7% forward yield thrown out by global companies. Moreover, HINT advised that some £230bn worth of dividends are shelled out by so-called vulnerable companies, representing 22% of the worldwide total.

How to spot a trap

It’s human nature to go hunting for the big bucks, but prioritising yield over everything else can prove disastrous for your long-term wealth.

As Ben Lofthouse, fund manager at Henderson International Income Trust, says: “Investors tempted by high yields alone are most at risk of falling into dividend traps. If you get caught in a dividend trap, you may find the income you hoped for is cut or has no prospect of sustainable growth. This eliminates one of the main advantages of investing in equities, which is for dividends to grow over time.”

So how can investors identify and thus avoid these dangerous income shares? Well, according to HINT, along with carrying a high yield these businesses tend to have:

  • Low dividend cover, which for these traps sit at 1.4 times on average, well below the 2.4-times non-trap average.
  • A high debt/EBITDA ratio, averaging 3 times for dividend traps and 1.3 times for non-traps.
  • Poor cash flow growth, which averages less than 10% for traps and 25% for other companies.

The most dangerous dividend stocks

Through its research, HINT discovered four different types of dividend trap: companies with high amounts of debt on the balance sheet; those facing disruptive competitive pressure, like telecoms and media businesses; firms hit by clampdowns by regulators, such as utilities; and firms facing severe structural threats, like retailers and car manufacturers.

What HINT’s analysis also shows is that, at the present time, telecoms, media and utilities businesses are the most likely to be income traps. Meanwhile, those involved in healthcare and drug manufacturing are viewed as some of the most secure.

Sector

Forward yield

Average yield of traps

Chance of a company being a trap

Communications & Media

4.8%

6%

44%

Utilities

4.2%

5%

39%

Oil, Gas & Energy

5%

6.1%

30%

Consumer Discretionary

3.6%

5.4%

25%

Consumer Basics

3.4%

6%

18%

Industrials

3.1 %

4.6%

16%

Technology

2.8%

5.5%

14%

Financials

4.7%

6.3%

14%

Healthcare & Pharmaceuticals

2.9%

4.7%

11%

It’s clear then that stock investing can leave you pretty badly burned if you go chasing yield above everything else. This is no reason to retreat into your shell, though.

Sure, equity markets can be full of pitfalls. But with the right attitude when it comes to trading and researching the market, it’s still very possible to make a fortune from dividend stocks. And particularly so at the current time with global dividends sitting at all-time highs.

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Royston Wild has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.