High-yield stocks often catch the eye of investors due to the seemingly significant, tangible returns on investment. Yet, not all that glitters is gold. In fact, it’s often the case that many names offering outsized yields are attached to a number of risks. Some mask such lurking risks beneath their attractive yields, these are known as dividend yield traps.
A yield trap occurs when a stock’s dividend appears enticingly high, often above the industry average or historical norms. Yet, what one can initially perceive as generosity can often be misleading, as it might stem from factors such as a declining stock price or unsustainable payout ratios rather than a high-payout business with healthy financials.
In my early investing journey, I found myself falling into yield traps. Over the years, I have seen both novice and seasoned investors alike often make the same mistake. Below, I share three dividend yield traps whose high yields should be approached with caution.
Leggett & Platt (LEG)
For some, it may be a bit surprising that I am including Leggett & Platt (NYSE:LEG) as a possible yield trap. This is because income-oriented investors hold this old furniture and bedding manufacturer in high regard. Having grown its dividend for 52 consecutive years, Legget & Platt has certainly earned the trust of investors seeking reliable payouts. Yet, I believe that its dividend growth streak may soon be coming to an end.
The very fact that shares of Legget & Platt have plunged by about 45% over the past year alone directly illustrates investors’ growing concerns. What underlies these concerns? It’s the company’s stagnant sales, declining margins and shrinking profits.
Increased competition in the space led to the company posting an 8% decline in sales last year. The decline in sales, along with the low-margin nature of the business, led LEG’s EBIT margin to turn negative. Thus, the company posted a loss per share of $1.00 for the year. This was the first occurrence of a GAAP loss in its publicly available data dating back to 1991.
Therefore, despite its legendary dividend growth track record, think twice before you jump Legget & Platt’s seemingly attractive 10.5% dividend yield.
Vodafone Group (VOD)
Vodafone Group (NYSE:VOD) is another name that is a potential yield trap. The UK-based telecom giant has experienced a continuous decline in its shares over the past decade. This trend has picked up in the past couple of years, as Vodafone’s mounting debt in the face of a rising rates environment has eroded investor confidence in the stock.
In its most recent financial report, Vodafone highlighted that it had managed to improve its debt position by 20.4% to €36.2 billion ($38.5 billion). This was made possible due to proceeds from the sale of Vodafone Spain. More recently, the company also announced it agreed to sell Vodafone Italy to Swisscom (OTCMKTS:SCMWY). Such initiatives should help Vodafone to deleverage further.
Nevertheless, Vodafone’s huge net debt remains a threat to its overall prospects and high dividend yield. Thus, while many investors tend to think of telecom giants as recession-proof investments, I would advise caution before investing in VOD.
Oxford Square Capital (OXSQ)
Oxford Square Capital (NYSE:OXSQ) could present another case stocks that are dividend yield traps. This business development company is currently trading at what seems to be a massive dividend yield of 13.5%. However, I believe that investors should carefully consider whether the underlying risks attached the their overall investment case are worth the potential trouble.
By trouble, I am talking about the company’s debt-oriented investment portfolio. In my view, I find to be of low quality and likely to underperform moving forward. Note that only 30% of Oxford Square’s portfolio comprises first-lien secured debt, while another 31% is exposed to high-risk collateralized loan obligation (CLO) investments.
CLO investments are generally considered high-risk, with a noteworthy chance of failing. Thus, Oxford Square Capital was forced to cut its dividend multiple times in the past, as many of its investments ended up eroding its net asset value. With rising rates increasing the possibility of failure in this particular asset class, the fact that the stock is trading at a huge yield reflects the market’s mistrust of current payouts.
On the date of publication, Nikolaos Sismanis did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.