How to Avoid Dividend Traps

As the economy took a downturn last year, many investors turned to dividends as a safe option for steady income. But what’s not safe is the assumption that all dividends are reliable, sustainable investment options. For example, many airlines1 cut their dividends at the beginning of the pandemic and have not reinstated them. But good dividends are out there and are usually offered by stable, well-established companies. To sort through the noise, there are several ways investors can avoid dividend traps and make wise investment decisions.

First, it is important not to let dividend yield drive decision-making. The dividend yield refers to the dividend amount in relation to the stock price. While a high dividend yield is tempting, it might signal unhealthy financial circumstances for the company. Many companies increase or begin offering dividend payments to compensate shareholders2 for stagnant or declining stock prices. Such behavior would indicate an unsustainable dividend and little future upside potential.

Instead, investors and portfolio managers should look at the dividend payout ratio. The dividend payout ratio1 represents the dividends paid to shareholders in relation to the company’s net earnings. An ideal dividend payout ratio is around or under 50%, which gives the company enough wiggle room for a safety net as well as significant capital to reinvest for future growth.

A ratio closer to 100%1 is a sign that the company is funneling nearly all of its net income to meet dividend payments. The company might also therefore need to borrow money and take on debt to pay those dividends. A high payout ratio can indicate that a cut is coming, but it also speaks more broadly to the mismanagement of funds on behalf of the company’s leadership. Companies with lower dividend payout ratios likely have lower dividend yield, but may therefore have greater share price appreciation over time as they reinvest their earnings in the business. 

However, high and low payout ratios can be relative. It is important to compare dividend payout ratios within similar sectors1 to get an accurate picture of the stock’s health. Utilities and consumer goods companies tend to pay higher payout ratios because they have more stable cash flow. Tech companies tend to pay lower dividend payout ratios because they need to reinvest to keep up with constant changes in the industry.

It is not enough to merely look at the dividend payout ratio and expect to know if a company makes for a wise investment. Portfolio managers should use fundamentals to look at the underlying business practices, dividend history, earnings growth, and profit margin among other characteristics of health. Companies that pay predictable and steady dividends tend to also have a steady business model, but only fundamentals will tell an investor how a company is spending its money and whether or not those practices should be relied upon by shareholders. 

The TrueShares Low Volatility Equity Income ETF relies on fundamentals to provide investors with healthy dividend exposure. The DIVZ portfolio manager maintains a concentrated portfolio of 25 to 35 well-managed companies in order to dig into the details of each individual holding. DIVZ avoids the common dividend traps to provide low volatility with long-term upside potential investors can count on.