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Here’s how you can avoid buying dud dividend stocks in 2015

Has the allure of big dividends ever been greater than it is now?

Interest rates are low.

Unemployment is at a 10-year high.

And the high share prices of our favourite stocks have pushed down dividend yields.

So it’s little wonder why investors are searching the beaten-up sectors of the Aussie economy – like resources and retail – for big yields and low P/E ratios.

That’s all well and good, if it’s done correctly. Unfortunately, for everyday mum and dad investors, it rarely is.

Too many investors fall foul of what experts call ‘value traps’. That is, those stocks which look like very compelling investments because they sport seemingly low valuations (say a P/E of five) and a ridiculously high dividend yield (like 6% or more).

In the share market, when something’s too good to be true, it generally is.

Take for example, Fortescue Metals Group Limited (ASX: FMG) and Monadelphous Group Limited (ASX: MND) which currently have P/E ratios of 4 and 6, respectively.

According to my stock broking account, they have dividend yields of 6.2% and 13%, fully franked no less! Indeed, these two appear to be the definition of value trap.

Looking backwards, investors who thought they were bargains last year are currently sitting on losses of over 50%. Worse still, analysts are forecasting a significant cut to their dividend payouts in the next 12 months.

But I’d say even the forecasts are looking a little too high because both companies are facing huge headwinds they have no control over.

Even retail stocks, such as JB Hi-Fi Limited (ASX: JBH) and Super Retail Group Limited (ASX: SUL), which are known to be extremely fickle, would make better dividend stocks at today’s prices. But they too are being affected by things outside their control.

Why would they make a better dividend stock? I hear you ask.

Aside from the intense capital expenditure requirements of resources companies like Fortescue, retailers at least have some degree of competitive advantage. After all there’s only one JB Hi-Fi.

However its economic moat (competitive advantage) isn’t very wide and it too is facing disruption, from the emergence of things like online shopping.

So the key for all long-term investors who want a regular income from the sharemarket is to identify the companies which can reliably and sustainably grow profits over the long term.

The performance of investing greats like Warren Buffett and Charlie Munger has shown us that this is best done by investing in companies with durable competitive advantages.

This can means that if they raise prices, customers are still compelled to buy. Toll roads, railways and infrastructure owners are prefect examples of those with wide economic moats.

Just think of your local freeway. It would be very difficult – and hopefully not worth the effort – for a new competitor to come in and build another road right beside the existing one. Especially when the incumbent is investing to upgrade their freeway.

If Transurban Group (ASX: TCL) – owner of toll roads such as Hills M2 and Citylink, as well as Cross City and Lane Cove tunnels – slightly raised prices, would you go elsewhere? Perhaps you would at first. But they know you won’t get to work as quickly.

What about Telstra Corporation Ltd (ASX: TLS), the company which regularly prices its mobile plans higher than everyone else? Its total number of subscribers continues to increase despite the premium consumers are forced to pay for its products.

Foolish takeaway

If investors only bought shares of companies with wide and growing competitive advantages (at a reasonable price, of course!), the chances of receiving a sustainable and reliable dividend yield would be greatly improved. However, it’s important to understand that even though a company can have a competitive advantage, very few of them will prove to be durable.

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Motley Fool Contributor Owen Raszkiewicz has no financial interest in any of the mentioned companies. You can follow Owen on Twitter @ASXinvest.

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