When hunting for yield, beware the dividend traps

Market Insider

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.

Dividend boosters

The strategists looked to the S&P 500 for non financial 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. A few 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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