3 Dividend traps to Watch For

Options traders may tend to think in the short term, but whether short-term or long-term, selection of the underlying should be based on sound fundamental signals; and dividends are not always positive for traders.

1. Basic math may cloak bad news

The math behind dividend yield can easily mislead traders, especially when there is bad news for the company. The lower the stock price, the higher the dividend yield, so in picking an underlying based on higher than average dividend yield, a little research can prevent a lot of pain.

For example, a pharmaceutical company has declared a dividend equal to 3%. The stock price is $80 and annual dividend is set at $2.40 (0.60 per quarter. This 3% yield is attractive, and at that level, buying stock and then employing options to hedge market risk or generate cash could make sense. But perhaps you are looking for high-yielding stocks for your options portfolio, so at 3%, you look elsewhere.

The following week, the company announces that drug trials did not go well, and the company has abandoned further research. The stock price declines to $62 per share. The day after that, another drug is rejected by the FDA and the stock price falls once again, to $48 per share.

All this bad news makes the company less attractive than ever, especially as management revises guidance for future profits due to these two instances of bad news. But at $48 per share, dividend yield is revised to 5% ($2.40 ÷ $48).

Even though the revised yield is the consequence of bad news, the stock now meets your criteria for purchase. You add the stock to your portfolio and begin writing covered calls. But was this a wise move? In fact, the future looks bleak for the company based on failed drug tests and FDA denial of approval. This points out the importance of thorough research beyond a single trigger. If your sole means for picking sticks is dividend yield of 5% or more, you might overlook the underlying cause and end up with poor portfolio holdings.

In this case, an “improved” dividend yield is the result of declining fundamentals. 

2. High dividend trends place strain on future expansion.

There is considerable strain on management to increase dividend per share every year. The attractive attributes of dividend achievers or dividend aristocrats motivate management in some instances to keep increasing dividend, just to qualify for the designation of exceptional dividend growth. But is this always a positive matter?

Dividend per share should be increased when earnings per share is improving. In that case, giving more earnings to investors through dividends makes perfect sense, and makes the company more attractive as an investment. But what if earnings decline?

In this case, increasing the dividend per share means a higher percentage of net earnings are paid out in dividends. If EPS has declined, what does this mean? It means that a lower percentage of earnings remain as working capital to fund current obligations and to expand. Over time, the higher dividend payout ratio begins to harm working capital, which of course is negative.

For options trading, strain on working capital translates to lost market opportunity and a cut in budgets to maintain profitability. Ultimately, for options traders, this is also a negative. Higher volatility in the underlying adds market risk to both stock and option positions.

By increasing dividends even as EPS declines, management decides to reduce working capital. Unfortunately, many investors decide to ignore the relationship between dividend yield and dividends per share. Management, as well as investors, believes that higher dividends are always perceived as positive trends, but it is not always the case. An informed dividend policy should be based not on the need to increased dividends per share every year, but on the limitations of EPS.

3. High dividends could translate into growing long-term debt

The most destructive management policy involving dividends is to increase the dividend per share even when the company loses money. For those options traders watching the fundamentals, it might be puzzling that a company reports a net loss but continues to increase its dividends per share. Attaining dividend achiever status easily ignores a reality of how destructive this can be to future cash flow.

The most likely way that a company increases dividends in years when a net loss is reported, is by increasing the long-term debt through issue of new bonds or acquiring long-term notes. This higher long-term debt funds dividends and maintains the illusion of dividend-based success. It may also maintain a healthy appearance in current ratio, a common measurement of working capital (increasing the balance of current assets through acquiring more debt is easily done, but it does not truly mean working capital is improved).

There is nothing illegal about a company taking on more debt to maintain its record of increasing dividends. But is it ethical? A more responsible policy might be to reduce the dividend per share or even skip the dividend altogether. This would be more beneficial to stockholders in the long run, even if the immediate impression would be negative. A reduced dividend or a skipped dividend is seen as a sign of failure, but in a period of net losses, it could be the most responsible decision by management.

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The dividend policies enacted by management should be motivated by long-term understanding of working capital and making tough decisions beneficial to stockholders. But the market culture tends to measure success blindly. Higher dividends, good. Lower dividends, bad. Unfortunately, the market pressure on management only promotes this thinking.

The solution for options traders: Avoid trading options in companies whose long-term debt continues rising each year. Check the debt-to-capitalization ratio to spot trouble in the debt and dividend trends. Seek companies matching dividend per share to earnings per share. That just makes more sense.

Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his websiteat Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.

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