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How to Spot a Dividend Trap (and Three to Sell Now)

Gordon Gekko, the sociopathic trader in the movie Wall Street, nonetheless imparted some useful investment advice in the iconic 1987 film. At one point, Gekko says of greedy investors who don’t do their homework: “They’re sheep, and sheep get slaughtered.”

Gekko’s harsh maxim could be applied to income investors who blindly chase high yields. They get slaughtered.

An exceptionally high dividend should set off your alarm and prompt a deeper dive into the financials. Below, I spotlight three high dividend stocks that are commonly found in retirement portfolios. I’ll explain why you should dump them now, before they cause pain. But first, let’s review the essential metrics you should weigh before buying any high yielder.

When looking for dividend stocks, it’s tempting to gravitate towards securities with the highest yields. This is not always the smartest strategy; there’s more to a worthwhile dividend stock than just a high yield.

In the second quarter of fiscal 2017, the total dividend payout for S&P 500 companies totaled $104 billion, an all-time high. The average year-over-year dividend increase for the S&P 500 was 10.5%.

Sure, robust dividends are offered by well-known companies with solid balance sheets. But high dividends also can be used by new or inherently weak companies as bait for investors.

A “dividend trap” is when investors hungry for yield are suckered into a high dividend yield, only to eventually discover that the underlying company is deeply troubled. That’s when the dividend gets cut or eliminated and unsuspecting investors get stung. Here are the key tell-tale signs of danger.

Burning through cash…

The dividend yield is calculated by taking the yearly dividend payment and dividing it by the stock price. For example, if the stock throws off $1 in dividends annually, and the share price is $50, the dividend yield is 2%.

One red flag is when the company pays a considerably higher dividend yield than its peers. Also keep in mind that yield moves inversely to price, which means extreme share price movements affect the dividend yield.

Consequently, event-driven declines in price can boost the yield. That’s when you need to decide if the fall in price offers an opportune entry point or if it’s a warning to shun the stock. If the balance sheet and fundamentals remain sound, a spike downward in price could be an opportunity to scoop up a high dividend stock while it’s on the bargain shelf.

Conversely, a stock in a sustained downward trend could prove toxic. The yield rises as the stock price drops, which makes the yield tempting, but the dividend gains are offset by capital losses.

When doing your homework on a dividend stock, it’s crucial to examine the payout ratio. The payout ratio reflects how much of a company’s net income is devoted to dividend payments. For example, if the company in a quarter generated earnings per share of $1.00 and paid a dividend of 60 cents per share, the payout ratio would equal 60%.

A low payout ratio can indicate the company is pursuing a long-term growth strategy by using most of its earnings to reinvest in the company. On the other hand, a high payout ratio can indicate management’s desire to share profits with investors.

Always be suspicious of payout ratios over 100%, because it means the company is paying out more than its earnings. The company is going into debt simply to pay shareholders, an untenable situation.

Another red flag is low cash on hand. Dividends can’t be paid without cash and a company that must quickly raise cash to cover a dividend is probably heading for trouble. Declining earnings combined with a high cash burn rate over a prolonged period are signs that the dividend may need to be cut in the future.

Three lurking traps…

Let’s put our rules into practice by applying them to three popular but risky high dividend stocks. If your retirement portfolio contains any of these widely held but dangerous equities, sell them pronto.

Mattel (NSDQ: MAT)

This toy maker is a household name, but it’s getting battered by more nimble and technologically advanced competitors. Iconic brands such as Barbie dolls are outdated in the Digital Era, with scant future prospects.

Meanwhile, arch rival Hasbro (NSDQ: HAS) enjoys tailwinds from its close relationship with the mighty multi-media marketing colossus Walt Disney (NYSE: DIS). Hasbro is beating Mattel to the punch with lucrative tie-ins to the Star Wars, Marvel and Disney princess franchises. Disney owns the Star Wars and Marvel names.

Hasbro also has been behind the curve in terms of adapting to video games and computer apps; its more traditional toys and games have little appeal for younger kids weaned on smartphones and apps.

Mattel’s 3.72% dividend yield looks unsustainable at a payout ratio of 217.14% of profits. Another danger sign: The average analyst expectation is that MAT’s year-over-year earnings growth this year will decline by 25.40%.

Pushing up MAT’s yield has been the stock’s dismal long-term performance. Shares are down 41.13% year to date, down 51.86% over the past 12 months, and down 29.26% over the past two years. It’s time to give Barbie her walking papers.

HSBC Holdings (NYSE: HSBC)

Based in London, this global investment bank has an extensive footprint throughout North America, Latin America, Europe, the Middle East, North Africa, and Asia. Problem is, the bank faces growing risk from Britain’s planned exit from the European Union, which is likely to hurt the international banking hub of London.

After initial optimism, Brexit negotiations have taken a turn for the worse and the unknowns are multiplying. Many global banks already are moving their headquarters from London to the competing center of Frankfurt, Germany.

Brexit also could weigh on Britain’s £229 billion annual trade with the EU, because of new trade barriers and tariffs. A primary advantage of EU membership is free trade among member nations, which makes exporting goods to other EU countries cheaper and easier for British companies. Gathering anti-globalist winds on both sides of the Atlantic should rebound to HSBC’s disfavor.

While all global banks are suffering from the uncertainty caused by gyrating crude oil prices and nervous markets, HSBC is in a particularly vulnerable position given its exposure to the weakest overseas markets. In the face of limited earnings inflow, the bank has been cutting costs but it will have to keep digging deep into its pockets to fulfill its dividend commitment.

HSBC’s dividend yield is high at 4.16% but the payout ratio comes in at a troubling 510%. Return on equity is a paltry 2.07%. Shares currently trade at about $48 and the average one-year price target among analysts who follow the stock is $41.22, representing a decline of 14%. Making matters worse, the bank is currently under investigation for an illegal currency trading scheme.

CenturyLink (NYSE: CTL)

As a mid-sized telecom and Internet provider (market cap: $11.2 billion), CenturyLink is mired in a slow growth, low-margin business.

In a 2017 second quarter that generally proved strong for corporations, CenturyLink racked up another dismal report card. CenturyLink’s second-quarter earnings came in at $17 million or earnings per share (EPS) of 3 cents, compared to $196 million or EPS of 36 cents in the same year-ago quarter. Adjusted EPS of 46 cents missed the analyst consensus estimate of 49 cents. The second-quarter bottom line on a year-over-year basis plunged 26.98%.

The company continues to witness a long-term hemorrhaging of subscribers. As of June 30, 2017, total access lines declined 5.95% year over year. The number of high-speed broadband subscribers fell 2.03%.

As with Mattel, CenturyLink’s stock has performed badly. With a seemingly alluring dividend yield of 10.47%, the stock is down 14.17% year to date, down 26.42% over the past 12 months, and down 21.20% over the past two years. The payout ratio is a worrisome 313.40%. If you own CenturyLink, disconnect immediately.


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Obscure Tax Law Forces This Company to Pay Out 90% of its Profits

A 50-year-old loophole is forcing one company to pay out $9 of every $10 it makes from ironclad contracts with the U.S. Government.

In fact, over the past seven years, it’s made payments ranging from a few dollars… to tens of thousands of dollars… 30 times. Without a single cut! 

Most folks don’t even know this company exists, but the ones that do are making a mint.

Like Ted B., who’s set to receive a check for $1,096 just a few days from now.

Merrill H., a 58-year-old from New York, has collected over $3,385 so far. 

And retirees Beth and Terry P. have raked in $16,555.

I’ve put together a special report that will give you all the details, including simple instructions on how to get your name on the payout list before the next cutoff date.

You can get your copy here.

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