It's the thing that keeps many an ASX dividend investor up at night: the dreaded dividend trap. Buying any ASX share is always an act of balancing risk with reward. And it's no different when it comes to income-producing shares.
Ideally, a quality ASX dividend share gives investors a secure, predictable and rising stream of dividend income (preferably fully franked). However, no ASX dividend share is under any obligation to continue a dividend policy year to year.
As such, it can make it difficult to know which shares are going to grow into that role of a reliable payer of growing passive income over time, and which are going to end up cutting their dividends.
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What is a dividend trap?
The latter situation is what's known as a dividend trap. A typical dividend trap goes something like this. You notice that a share has a huge trailing dividend yield, say 10%. You check the company's last two biannual dividend payments, and all seems well. That 10% yield looks legitimate. So you buy a chunk of shares, hoping to make back your investment capital in dividend income alone over a decade.
But then, your new share announces that, due to some circumstance, it is unable to pay the next dividend at the same level as the last one. Your share's stock price immediately plummets, and you're left holding the bag.
The bag in this case is the tough choice of selling out and crystallising your capital loss, or else holding on with the hope that things will get back to the way they were. This tough choice is the crux of the dividend trap, and it's a situation no one wants to be in.
So that's why it's a big deal when an ASX expert labels a prominent ASX dividend share as a classic dividend tap.
That's exactly what has happened this week, according to reporting in the Australian Financial Review (AFR).
Peter Gardener, portfolio manager of Plato Investment Management's Australian Shares Income Fund, is the expert who has just spoken to the AFR about dividend investing.
The share that Gardener labelled a dividend trap is none other than ASX financials share and fund manager Magellan Financial Group Ltd (ASX: MFG).
Magellan has been a famous Icarus stock – a former high flyer that has fallen dramatically back to earth.
Why this ASX expert is telling income investors to avoid this stock
Back in early 2020, Magellan shares were soaring at close to $70 a share. But a series of very unfortunate events, which we've extensively documented, has resulted in the company having a share price of just under $7 today.
Here's what Gardener had to say on Magellan as a dividend investment:
Magellan Financial Group has been a classic dividend trap in recent times and in our view, it remains so today.
It has traded on a gross trailing yield of over 10 per cent for quite some time as the company's share price has been collapsing. We saw it cut dividends in 2022, and saw further cuts through this year, and our expectation is there'll be even more to come in 2024 as the former market darling continues to face big challenges.
It's not hard to see why Gardener has come to this conclusion. Magellan, as a fund manager, can only really rely on two factors to boost its earnings. Those are the level of funds under management (FUM) for its investments, and the return that its investment portfolios can deliver.
It's the former that is most concerning at present. Due to this company's shattered reputation after an avalanche of scandals, management exits and uncertainty, investors have been heading for the door seemingly every month.
In early October, we covered Magellan's latest FUM figures. And they weren't pretty. The company lost 10% of its FUM over September 2023 alone, with Magellan going from $39 billion in FUM at the end of August to $35 billion by the end of September.
If Magellan is deriving most of its earnings from its FUM pool, this obviously bodes ill for its capacity to pay out the $1.17 per share in dividends (including a special dividend) that investors have enjoyed over 2023. In fact, that $1.17 in dividends per share this year was a big drop from the $1.79 in dividends per share that was paid out over 2022.
As such, it's easy to see where Gardener is coming from here. At the current Magellan share price of $6.87, this ASX 200 stock has a trailing dividend yield of 12.57%.
