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  • Income Investing

    Chasing Yields and Avoiding Dividend Traps

    January 28, 2019

    Dividends have long been the primary way businesses distribute cash to shareholders, and investors find appeal in their income stream and contribution to long-term total return from equity markets. Sometimes, however, investors can be attracted to a dividend-paying stock with seemingly attractive yields, only for the company to experience financial distress, dividend cuts, and a falling share price—in other words, a “dividend trap.”

    Chasing short-term yield alone may come at the expense of long-term total return. Cautionary tales from recent years include financials and housing-related stocks in 2007-2009 and energy and materials stocks in 2014-2015.

    The Morningstar U.S. Dividend Valuation Index offers exposure to companies with significant dividend payouts that are also attractively valued and financially healthy. The Morningstar whitepaper, Dividends with Discretion, provides an in-depth look at the index’s selective, rules-based approach to identifying dividend-paying companies with relatively attractive valuations and with strong financial health, which is linked to dividend durability.

    The whitepaper examines the long-term total return contribution of dividends and the historical outperformance of dividend-paying companies, as well as the key risks dividend investors may face, including interest rates, valuation, and dividend traps. It then provides a detailed look at two key assessments from the Morningstar equity research team that are used to determine index constituents: its forward-looking valuations, based on forecasts of future cash flows, and its dynamic Distance to Default indicator for measuring financial health.

    Download the full Morningstar whitepaper, Dividends with Discretion, to learn more.

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