Dividend warning: Are these big yields a trap?

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Dividend warning: Are these big yields a trap?

Those on the hunt for high yields at the start of 2018 need to tread carefully, as some income promises will inevitably not be kept.

High dividend yields look attractive on paper, but should be treated with a healthy dose of scepticism. As share prices and yields have an inverse relationship, a high yield is more often than not a sign that a stock, for whatever reason, is out of favour.

Therefore, the big danger when it comes to buying shares with high dividend yields is that investors can end up unwittingly buying a 'value trap' - a share that is in trouble and unlikely to keep its income promises.

To help investors avoid potential value traps, our dividend danger zone screen highlights shares that may struggle to deliver on the income front. When we began the series at the end of November last year a total of six shares featured in our table.

Upon re-running the screen at the start of January, there were once again six shares, although these included two changes, with Imperial Brands (IMB) and National Grid (NG.) entering our dividend danger zone table. Essentra (ESNT) and SSE (SSE) exited, having seen improvements in their dividend sustainability scores.

The screen, set up by Simon McGarry, a senior equity analyst at Canaccord Genuity Wealth Management, filters through the 700-odd names in the FTSE All Share index (ASX) and adds the following filters: a market cap of over £200 million, a dividend yield of 4% (higher than the FTSE 100 (UKX) average) and a dividend cover score of below 1.4 times.

Two other filters were also applied: the first filtered out companies that appear in a financially sound position to pay off their debts, while the second excluded firms where earnings have been upgraded by analysts.

Stock in focus: Centrica

Each month our sister website Money Observer will look more closely at an individual stock that features in the dividend danger zone. This month it has chosen Centrica (CNA), the owner of British Gas.

The stockmarket rarely offers investors a free lunch, which is why a dividend yield of 8.1% should be viewed with caution.

From hitting a peak of 402p in September 2013, Centrica's share price had slumped to around 140p at the start of 2018. There are have been a number of headwinds, but most alarming of all is the fact that British Gas has been losing large numbers of customers. Between July and October 2017, 823,000 voted with their feet, which led Centrica to warn that earnings during 2017 would be lower than it had expected.

McGarry points out that retail power and natural gas markets are highly competitive, with virtually no barriers to entry, minimal brand loyalty and low switching costs. "As a result, retailers are increasingly being forced to compete on price. At the same time retail energy margins remain under pressure on both sides of the Atlantic due to competition."

The proposed price cap on energy bills, driven by prime minister Theresa May, will lead to "material earnings headwinds", argues McGarry. He adds that under a Labour premiership led by Jeremy Corbyn, utility stocks could become an even bigger political hot potato.

Centrica has not been afraid to take an axe to its dividend in the past. In February 2015 the firm cut its dividend by 30% after operating profits disappointed.

This article was originally published in our sister magazine Money Observer. Click here to subscribe.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.