WARNING: It’s A Dividend Yield Trap
Imagine you're house hunting, and you find what looks like the perfect property in a great neighborhood with a big "For Sale" sign, and an irresistible tagline: "Amazing Value with Bonus Features!"
Sounds like a winner, right?
However, upon closer inspection, you discover that the foundation of the house is shaky, the roof leaks, and the plumbing is outdated. The bonus features, in this case, were highlighted to steer your attention away from the essential problems with the house — the problems that make the house inhabitable.
In the world of dividend investing, this is what you’d call a certified “yield trap.”
A yield trap is a situation where an attractively high dividend yield masks underlying issues within a company, eventually leading to disappointment for investors.
Investors are drawn in by the delicious dividend yields, but when dealing with a yield trap, those yields are unsustainable and/or are driven by deteriorating company fundamentals — the trap is set.
These investments may appear lucrative on the surface, but they’re usually too good to be true. The dividends may be at risk of a reduction, and the overall investment may lead to pretty big losses.
Fortunately, yield traps are pretty easy to identify.
The quickest way is to look for negative dividend growth and a track record of dividend cuts over time. If a company consistently reduces its dividend payments, or if the dividend yield is artificially high due to a sinking share price, take it as a sign to avoid at all costs.
We can look at examples such as:
Invesco Mortgage Capital (IVR) — 17.84% yield
Orchid Island Capital (ORC) — 17.41% yield
Annaly Capital Management (NLY) — 13.29% yield
…or any of the stocks in this video here.
It’s easy to be tempted by their double-digit yields, but all of these companies have an unfortunate tendency to reduce their dividend payments over time. That’s the exact opposite of what you want in an investment.
Source: Seeking Alpha | ORC Dividend History
To add insult to injury, all three of these companies have drastically underperformed the S&P 500 over the last decade, and if you had invested in IVR and ORC during that time period, you'd actually be counting losses instead of gains.
Source: Seeking Alpha | Total Return vs S&P 500
Just as a homebuyer should prioritize the condition of the house over the bells and whistles, an investor should focus on the fundamental strength of a company and its long-term prospects instead of chasing a high dividend yield.
And don’t get me wrong, that’s not to say that all high-yielding stocks are bad. They’re just not all made the same.
Overall, while high-yielding dividend stocks can offer that immediate income gratification, it’s the dividend growth stocks (like the seven great ones in this video here) that are the REAL secret weapon for building long-term wealth.
With that said, I want to hear from you: Which stocks do you think are yield traps? Write to me here and let me know.
And a big thank you to the 28 readers who responded to last week's newsletter! You can read some of the responses down below in the "Hot Takes" section. 👇
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5 Market-Beating Dividend Stocks To BUY & HOLD FOREVER 💰
Reaching financial freedom with dividend investing is not about making frequent trades in and out of stocks. In fact, that approach can often lead to subpar results, which is why in this video we’ll be talking about 5 market-beating dividend stocks to buy and hold forever.
These are great dividend payers that have a history of actually outperforming the market, and I think they’re ones you can feel good about owning to collect that sweet, sweet dividend income for a long time.
CAREFULLY CURATED 🔍
📺 Retirement Is A State of Mind - Retirement is often viewed as the end of something rather than the start of something new, but that might be a mistake. Many people achieve much more when they retire than they ever did at work, finally having the time to pick up on their interests, and indulge in the things they care about. This is why we look forward to financial freedom so much, but you don't have to wait until a certain age, or until your career ends to start doing the things you enjoy.
🎧 Go Global - This was one of the best episodes of the Richer, Wiser, Happier podcast that I've ever listened to. I hadn't heard of the guest before, Laura Geritz, but she's the founder of Rondure Global Advisors. In the episode, they talk in-depth about her unusual lifestyle, which is built around relentless travel, voracious reading, and having abundant time to think. Sounds like she's living the dream.
📚 Dividend Investing Like Charlie Munger - According to Charlie Munger, lifelong learning and lifelong companionship pay dividends (both literally and figuratively), and this great article shares four lessons from Charlie that all dividend investors can learn from.
SINCE YOU ASKED 💬
"Which metrics are important to look at when analyzing a dividend stock apart from its dividend metrics?"
- @raghuredstig | YouTube
This is a great question, and I'll try not to make it too lengthy. Dividend stats aside, here are a few key metrics to consider when analyzing a company:
Revenue and Earnings Growth: Look for companies with consistent revenue and earnings growth over the years. A growing business is more likely to sustain and potentially increase dividend payouts. Plus, share price movement tends to follow earnings growth.
Stable or Growing Profit Margins: Check the profit margins to ensure the company is efficiently managing costs. A stable or growing profit margin is a positive sign of a healthy business.
Ample Free Cash Flow: Free cash flow is critical for a company to cover its dividend payments. Ensure there's enough cash generated after operating expenses and capital expenditures to comfortably sustain and potentially grow dividends.
Manageable Debt Levels: Excessive debt can strain a company's ability to maintain dividend payments, so you'll want to make sure the company has a manageable debt level. I like to evaluate the net debt in relation to the company's annual free cash flow.
If the company can clear all its debt within a few years using the free cash flow, that's a good sign to me. It's even better if the company's debt is negative on a net basis. This means they have more cash and short term investments on the balance sheet than total debt.
Have a question? Ask me here to see it featured in an upcoming newsletter.
HOT TAKES 🔥
Last week, I asked readers how they were able to overcome the "boring middle" of investing. Here are some of the responses:
Pat said: I sit in it. I don't try to overcome it. Investing is like marriage. You gotta really know what you're investing in beforehand, trust that you made the right decision, and stick to the plan you set out at the beginning of your journey. If it gets boring that means it's working.
John said: One way I overcome the “boring middle” is by reading books, listening to educational YouTube, or sharing my thoughts or progress with close friends, family or coworkers. It's obvious that nobody likes waiting, but if you want to succeed in life, you strive for patience first.
Mark said: I'm currently 18 and a half years into investing in my 401(k), and first 10 years seemed like such slow growth. With the economy the past 4 years, it's made for a bit of a roller coaster, but if I look, I'm up close to 50% since 2019, which is crazy. I'm starting to read multiple Warren Buffet books, along with two put out by Peter Lynch, and just have to remember that "time in the market beats timing the market".
Ron said: I’m not sure that I ever experienced the boring middle of investing. Perhaps it is because I was an accountant and never tired of counting and tracking our finances. Even now that I am retired and living off of our dividends, I still love looking at and optimizing our investments. However, I do acknowledge that I miss the big gains that I used to see when we were adding money to the pot. But I have actually gotten the son of a friend into dividend-growth investing and I am helping him build his portfolio. I’m now getting that rush (at least I find myself smiling) whenever I see that he has added money to his account and I show him how much each contribution has added to his passive income and what his forecasted portfolio balance and dividend income could look like years out into the future.
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