Market Insider

When hunting for yield, beware the dividend traps

Key Points
  • High-dividend paying stocks may be riskier than investors think, if the company ends up cutting its dividend.
  • Bank of America Merrill Lynch strategists screened stocks of all sizes to see which have the potential to cut, raise or even initiate dividends.
  • They also found those steady firms that have a long track record of dividend growth.
A trader looks at price monitors as he works on the floor at the New York Stock Exchange.
Brendan McDermid | Reuters

With low interest rates and stocks stuck in a sideways range, dividends are an important way to generate income for many investors.

But it's also important to know when a company may potentially cut its dividend. Bank of America Merrill Lynch equity strategists screened stocks of all sizes for those that may be ready to pare back dividends, but also those that may be set to raise them, and or even start to make payouts.

"High dividend yielding companies can be traps at this point in the cycle, as they may signal prices falling precipitously ahead of dividend cuts," the strategists wrote.

The strategists screened the Russell 3000 for companies at risk of cutting payouts. They looked at those that pay more in dividends than they generate in free cash flow. The strategists also looked at those that have over 100% payout ratio and are more levered than industry peers.

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Some companies at risk of cutting dividends also have weak debt ratings. Several on the list, with debt rated BBB-, a step above junk, include EQT, Omega Healthcare Investors and Office Properties Income Trust. Another with the BBB- rating, Kraft Heinz, already cut its dividend this year but is also viewed as likely to make another cut. The strategists said these types of companies may be more motivated to clean up balance sheets than maintain dividends.

Also on the list of companies that could cut payouts are Macerich Co, Pattern Energy and Sabra Health Care REIT, all of which are rated neutral by BofA stock analysts.

Dividend boosters

The strategists looked to the S&P 500 for nonfinancial companies that could boost their payouts. They screened by low leverage versus their sectors and a ratio of free cash flow to dividends that was greater than 1 for the past 12 months, among other measures. Names from that list include Target, Costco, Mastercard, Textron and Sealed Air.

The strategists also screened the S&P 500, aside from financials, for companies that could initiate dividends. They looked for companies with stable and growing earnings and cash as a percentage of market cap of at least 2%, as well as other metrics.

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Companies that made this list include Intuitive Surgical, F5 Networks, PayPal Holdings, Ulta Beauty and Monster Beverage.

The strategists also looked at the S&P 500 for companies that consistently raise their dividends. They studied the period between 1980 and 2018 . Eighteen companies had dividends with a compounded annual growth rate of 10% or more in that time.

Walmart tops this list, with a rate of 21% compound annual growth rate in that period. Others on the list include Medtronic and McDonald's, both at 16%, and Johnson and Johnson, Coca-Cola and Pepsico.