How to Spot a Value Trap

A generous dividend payout is enticing but it’s not always a positive sign. Here's how to avoid falling into a dividend trap 

Nicki Bourliofas 17 March, 2021 | 10:00AM
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Giant bear trap

As some shares fall in price, investors need to be on the lookout for value traps. While a low price can be lure for investors, it doesn’t necessarily indicate good value and investors must know how to spot warning signs such as a disruption to the company’s business or industry.

Investors can use Morningstar’s star ratings for stocks to determine whether a company is trading above or below its fair value. Morningstar analysts' estimates of fair value consider the characteristics of the underlying business, including future cash flows and the risk inherent in the stock.

A rating of 4 or 5 out of 5, for example, indicates the share’s current price is below its fair value and there is a margin of safety, while a 1- or 2- star rated stock, indicates that at the current price, the share is not good value.  

“We view that star rating and the company's fair value as a principal measure of a company's margin of safety,” says Adam Fleck, Morningstar’s head of equity research for Australia. “If a company has a rating of 3, it is roughly fairly valued so it isn't a great deal, but the investor should earn a reasonable rate of return. With a rating of 4 or 5, the market is pricing in an overly negative outlook and there is a margin of safety."

Knowing What to Look For

For investors keen to do their own research, Maroun Younes, co-portfolio manager at Fidelity Global Future Leaders fund, says the first thing to do is to identify the cause of the current low price, and whether the reasons for it are temporary or permanent.

“If the underlying cause is structural or permanent, such as a new disruptive technology emerging, then it’s more likely to be a value trap,” says Younes. Conversely, a cyclical downturn in the sector, a broader economic recession, or a few simple management missteps that can be easily rectified could present a good buying opportunity. 

Another factor to closely examine is the company’s balance sheet, says Younes. “A stressed balance sheet lowers survivability rates, as well as restricts options available to management. Good bargains should ideally have healthy balance sheets.”

Rehder also warns against dividend traps, where shareholders buy shares simply because the yield is high. Identifying dividend traps requires the investor to understand a company’s health and whether its dividend payouts are sustainable. “In order to determine dividend sustainability, a clear view on whether the dividend is supported by sustainable earnings and free cash cashflow is needed,” he says. One useful measure to look at here is the dividend cover, something we analyse in our monthly round-up of top dividend paying FTSE 100 stocks

3 Causes of Dividend Traps

Neil Sutherland, partner at fund manager Dundas Global Investors, says there can be three causes for a dividend trap, where both the dividend goes down and the price goes down over time.

1. Very high pay out ratios

2. High levels of debt

3. The difference between profits and cash

“Each of these less-than-desirable situations are known as dividend traps—an attractive yield that is too good to be true," says Sutherland. 

High pay-out ratios mean companies are not investing sufficiently in their own business to drive real dividend growth. In some businesses there can be a big difference between stated profit and the cash flowing into the business, thus placing the dividend under threat.

Sutherland adds: “The likelihood is that underinvestment in research and development and/or capital expenditure will mean a company will be less competitive over time, resulting in flat or falling revenues, ultimately in a dividend cut. Dividend cuts are typically hugely erosive to share prices."

Firms with high debt levels may also be driven to cut their dividends in tough times, either due to rising rates or merely they cannot stretch further, and the dividend is under too much pressure.

There were 401 companies out of 1547 within the MSCI World index in 2020 that cut their dividend, compared to 157 in 2019. “A keen eye is required in 2021, to focus on company financials to hopefully witness the world’s dividend recovery,” says Sutherland.

But knowing how to spot a value trap can help investors avoid dividend disaster, as Morningstar's Dan Lefkovitz recently investigated

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Nicki Bourliofas  Nicki Bourlioufas is an Australia-based contributor to Morningstar on personal finance