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Using moats to avoid dividend traps

Dan Lefkovitz  |  24 Jul 2018Text size  Decrease  Increase  |  
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Successfully chasing yields while avoiding 'dividend traps' can be tricky for investors, but there are tools that can help.

Chasing yield can lead investors to risky corners of the market. The past decade is littered with instances of dividend traps, such as financial services stocks in 2008-09 and energy and materials in 2014-15.

Investors reliant on backward-looking indicators, such as a company’s dividend-paying history, have been burned. Companies can be reliable payers – until they’re not.
In 2010, Morningstar designed a forward-looking approach to rules-based passive equity income investing: the Morningstar Dividend Yield Focus Index. At the time, we showed that proprietary metrics can screen out companies at risk of cutting their payout. Since the index methodology has globalised, we updated and expanded the study into the efficacy of the metrics.

A complicated relationship

Intuitively, higher interest rates make cash and bonds more attractive relative to dividends. For this reason, dividend payers often take a hit when rates rise. But longer term, does equity income struggle in higher rate environments, and vice versa?

We examined the relative performance of dividend-paying stocks in different interest-rate environments. We looked at returns for higher dividend payers against the 10-year government bond yield in several markets—the US, the UK, Germany, Japan, and Australia.

The results for Australia, which are displayed below, demonstrate no clear pattern. In some periods of rising rates, high-yield equity actually outperformed, and vice versa. In other regimes, the conventional wisdom was borne out.

yield dividends Australia interest rates

This pattern holds across markets studied. The wider context matters. Dividend investors should fret less about interest rates and more about moats.

Wider moat, lower risk

In our latest paper, we found that Morningstar’s metrics for quality and financial health have global utility for dividend investors. The Morningstar Economic Moat Rating is assigned by equity analysts to 1,500 companies globally. The Quantitative Economic Moat Rating algorithmically mirrors the analyst-assigned rating and extends the coverage universe across developed and emerging markets.

 

Percentage of dividend cuts by rating level

moat analyst

 

Both ratings are meant to describe the strength of a firm’s competitive position, gauging the sustainability of profits that ultimately fund dividends. Distance to Default gauges financial health, forecasting the likelihood of bankruptcy.

In each region, the trend was the same. The wider the moat and the higher the Distance to Default score, the less likely for a company to cut its payout. By screening the dividend-paying universe for these metrics, the Morningstar Dividend Yield Focus Index family focuses on sustainable yield. It offers a selective, forward-looking approach to equity-income investing.

 

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Dan Lefkovitz  is content strategist for Morningstar’s Indexes group.

© 2018 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.

is content strategist for Morningstar’s Indexes group.

© 2019 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782. The article is current as at date of publication.

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