When you see a popular ASX dividend stock trade with a dividend yield of almost 10%, you might be tempted to rush out and buy it straight away. After all, a 10% yield represents phenomenal cash flow potential. You could get nearly $10 back every single year for each $100 invested. That's twice what a good term deposit is paying right now (even with our currently high interest rates). And it's more than two what most other blue chip ASX dividend stocks are yielding.
The popular ASX dividend stock I am referring to is none other than WAM Capital Ltd (ASX: WAM). Yep, WAM Capital shares are, at the time of writing, asking $1.58 a share. At this price, the listed investment company (LIC) is trading on a dividend yield of 9.84%. Today, let's discuss this dividend yield, and why yields at this height are usually a waving red flag.
As a LIC, WAM Capital owns and manages a portfolio of underlying investments on behalf of its shareholders. In WAM Capital's case, this portfolio is made up of "undervalued growth companies", usually of the small- to mid-cap variety, that WAM Capital has identified as possessing some kind of pricing catalyst that will see their value rise in the near future.
Some current holdings (as of 31 July) include Eagers Automotive Ltd (ASX: APE), Codan Ltd (ASX: CDA), DigiCo Infrastructure REIT (ASX: DGT), and Zip Co Ltd (ASX: ZIP).
WAM passes on any profits made from its arbitrage trades, as well as any dividends it receives from its holdings, on to investors in the form of its own dividends.
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Why this ASX dividend stock's near-10% yield is a red flag
A company's dividend yield is a function of its share price just as much as its underlying dividend per share. As such, anyone who spots a company with a yield this high must ask themselves why the market is pricing it that way. The answer is usually that there is a high level of risk associated with that yield.
So where does the risk come from in the case of this particular ASX dividend stock? Well, let's go through some numbers.
Since 2018, WAM Capital has paid out two dividends a year, each worth 15.5 cents per share. However, the company tells us that, again as of 31 July, it had just 13.3 cents per share in its profit reserve. That's the pot where its dividends are funded from. There's clearly not much left in the tank. If WAM Capital doesn't replenish those profits soon, investors are at serious risk of a dividend cut. If that does eventuate, that 9.84% yield wouldn't be long for this world.
This company doesn't exactly have a glowing history either. For whatever reason, WAM no longer lists its recent performance figures on its site. However, a quick look at its share price will tell you all you need to know. Today, WAM Capital shares are trading at the same level they were way back in early 2002. Over the past decade, its share price has lost about a third of its value, probably not assisted by the company's rather hefty 1% per annum management fee.
Foolish takeaway
That tells us that its dividends are the only real source of shareholder returns. Given the apparent precariousness of these payouts, it's not hard to see why the market is pricing in so much risk to that yield.
Sometimes, a yield that looks too good to be true just might be that. Investors should always tread with extreme caution when red flags this large are waving in the wind.
