It's been a good year so far for investors, with the Australian and global markets continuing their rally. However, despite these solid gains, investors continue to fall for the "dividend trap", where they blindly buy companies on the basis of strong dividend yields.
Our historically low interest rate of 2.5% has given investors an incentive to find some better deals, particularly in equities. But if you don't pay the right price for a stock you'll end up with little, if any, gains. It's therefore vital to look for companies that offer both enticing growth prospects and dividends at a relatively cheap price, since without any earnings growth, companies may be forced to cut back on dividends.
Here are two stocks that I've identified as potential "dividend traps" and investors should be aware of the price they pay when it comes to an entry point.
1. National Australia Bank
Financial services group National Australia Bank Ltd. (ASX: NAB) provides a wide range of banking solutions and wealth management for its customers throughout Australia, New Zealand, Asia, the United Kingdom and the U.S.
NAB has been one of the weaker performing companies in the financial sector, slightly underperforming the Australian market in the past decade. Investors should not be fooled by NAB's fully franked 5.5% dividend yield. A further look into its fundamentals reveals that NAB's performance has become a bit shaky largely because of its struggling UK businesses, weighing down on its better performing regions since the global financial crisis.
NAB has taken the initiative of offloading some of its struggling UK businesses, closing 28 branches which will provide approximately $5 million in savings, but the constant uncertainty that surrounds NAB ultimately weighs down on its valuation.
NAB may trade on a relatively cheap price-to-earnings ratio of 13.17, but in my opinion it doesn't seem to offer enough value given a lack of long-term tailwinds and its shaky businesses.
2. Telstra
Australia's largest telecommunication provider Telstra Corporation Ltd (ASX: TLS) has been the talk of the week, boosting its full-year net profit by 14% and raising its final dividend by 1 cent to 15 cents per share. This takes its dividend yield to a stunning 5.3%.
Unlike NAB, Telstra appears to have some decent long-term tailwinds that have the potential to drive its future earnings, given the world's reliance on smartphones and internet related devices.
However, the problem with Telstra is that shares are not cheap. Telstra shares have recently skyrocketed, hitting 12-year highs and despite these tailwinds, analysts don't seem very optimistic about future earnings growth.
Although it offers some promising tailwinds, investors shouldn't fall into Telstra's "dividend trap" and I think a lower entry point is a must in order for Telstra to fall into the buying range.
