Saturday, 9 January 2016

The Dividend Trap

Looking at the sea of red suddenly gives me a lot of inspiration to write. In times of peace I was like in slumberland (for finance blogging). So while I am awake, I wanna shoot this very trendy investment term - DIVIDEND.

Is dividend yield most important when you make a stock selection?

Do you frequently look at dividend trackers?

Is your investing goal or objectives mostly revolving around dividends?

If all your answers are yes, then you might have fallen into the 'Dividend trap'.



Since Dividend yield = Dividend yield ($) *100/ Price of share ($), when there is rapid market melt-down what do you think happens? Dividend yield shoots up! Then you thought GOOD AH, BUY AH! Passive income ah!

If you scrutinize further, often those stocks which dividend yield shoots up like crazy (in beyond 10% range) are often companies which are most impacted by the ongoing economic changes or the weaker ones with say higher liabilities, weak earnings or poor growth. This is because other investors are dropping them like hot coals.

In times when the market recover, would their share prices recover as fast? Are their business robust enough to weather the rough economies? Are their high dividends sustainable?

Some businesses that pays good dividends are cyclical. Meaning they do well when their industries do well and that explains the high dividend payout but once the spotlight is off and curtain's closed, the dividends would drop. One such example is oil-rig companies.

Some have inconsistent payouts. For instance, on some years there are special dividends due to asset disposal or exceptionally good earning. That one year does not represent the norm. So I would advise looking at their 5 years dividend payout history, otherwise 10 years.

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In conclusion, don't just happily filter stocks by checking highest dividend yields. Treat stock picking or stock analysis like watching 3D movies with surround sound - micro (stock indicators), micro (fundamental /moat) and macro (world economy), rather than looking at a snapshot. At times looking at PB, ROE, debt/price ratio or even P/E are not enough to justify a buy (as there are many ways to compare and judge), much less dividend yield.

I am sure you vaguely remember something about 'not to drive by looking at the rearview mirror'.

Dynamic factors changing ahead of you that affect these ratios are share prices, future earnings, future liabilities, assets revaluation etc.

At the end of the day, total capital return is what matter most.

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Buy a good company at fair price or a fair company at good price?
You make your choice.

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