Hot Money Monday: Dividend investors face challenges, but avoid “yield traps” with Morningstar’s Best Ideas list

Morningstar warns investors not to get caught in ‘yield traps’ – stocks that look attractive but have unsustainable earnings and are at risk of dividend cuts.

Best ideas from Morningstar. Pic: Getty Images

• FY24 was tough for income investors with falling dividends

• Energy and mining sectors under pressure from low commodity prices

• Dividend growth anticipated in consumer, industrials, and financials by FY26

FY24 was a tough year for income investors.

Although total dividend payments were pretty much unchanged compared to FY23, they dropped by nearly 10% compared to FY22 across sectors.

And when you factor in around 4% inflation, real income was very much affected.

The pain was most acute in the energy and mining sectors, where falling commodity prices impacted earnings and returns for shareholders.

Consumer stocks didn’t do much better, as they faced weak spending along with rising rent and wage costs.

Real estate trusts, which usually have higher debt levels, were hit hard by increased interest expenses.

Looking ahead to FY25, things don’t seem much brighter, according to Morningstar.

The basic mining sector, which makes up nearly a third of the dividend payments, is expected to struggle due to China’s slow growth.

It seems unlikely that steel production and iron ore usage will remain at peak levels after two decades of over-investment.

"We’re expecting mid-single-digit declines in dividends for this sector, and there could be even more cuts if commodity prices continue to fall," said Morningstar.

But by FY26, there will be improvements on the horizon.

Who will the big dividend winners?

Morningstar believes there are still some promising areas in the market.

The best dividend stocks aren't just those with the highest yields, says Morningstar, as this can lead to ‘yield traps’ – stocks that look attractive but have unsustainable earnings and risk dividend cuts.

“We think the big winners here will be the cyclical sectors – consumer, industrials, and financials – which should benefit from an upturn in economic activity as inflation cools and central banks ease monetary policy,” says Morningstar.

“But mining and energy still weigh, and given their outsized contribution to the index, we see total dividends only growing 2% — firmly below Treasury’s 3% inflation forecast.”

Keeping that in mind, here are the dividend prospects from Morningstar’s Best Ideas list.

This selection highlights companies chosen for their strong valuation and quality, making them attractive options for income-focused investors.

Morningstar’s best ideas list

APA Group (ASX:APA)

APA is the highest yielding stock on the list.

The company is primarily involved in the energy sector, and owns and operates a substantial network of natural gas pipelines and infrastructure.

APA focuses on transporting, storing, and distributing natural gas and electricity across Australia, serving both residential and commercial customers.

“The company has several attractive features, including a narrow moat arising from its unparalleled gas pipeline network,” says Morningstar.

“High capital costs and inelastic demand deter new entrants, resulting in a competitive advantage for incumbents like APA.

“The company also enjoys highly secure revenue, underpinned by regulation and long-term contracts, and we expect this to facilitate dividend growth of roughly 4% annually over the next five years.”

Aurizon (ASX:AUZ)

Aurizon is a leading freight and logistics provider, specialising in rail transportation and focusing on the movement of coal, iron ore, and other bulk commodities.

Aurizon owns and manages an extensive rail network across Australia, connecting mines and ports to facilitate efficient transport.

“Aurizon trades at an attractive 6% yield, mostly franked,” says Morningstar.

“We think some investors are losing patience with attempts to diversify away from coal via investment in non-coal bulk and containerised freight haulage.

“But Aurizon’s core rail-haulage and rail network businesses enjoy a narrow moat, holding significant cost advantages over road transport for bulk commodities.

“Earnings are defensive, and the outlook for dividend growth is strong, at a forecast 7% CAGR over the next five years.”

Domino’s Pizza (ASX:DMP)

While riskier than the two names above, Domino’s Pizza has the strongest dividend growth outlook on the list, says Morningstar.

“We think the market underestimates the massive growth potential of Domino’s global network, which we expect to approach 6,000 stores in ten years, from less than 4,000 today.

“As the network expands at a rapid clip, so too should dividends.

“Trading conditions have recently proved challenging, but Domino’s is a globally recognised, moat-worthy brand, and we forecast a rebound. On valuation grounds, Domino’s is also one of the cheapest names on our Best Ideas list.”

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Originally published as Hot Money Monday: Dividend investors face challenges, but avoid “yield traps” with Morningstar’s Best Ideas list