Dodging Dangerous Dividends

Why do junk bonds have such an unattractive name? They can be great investments, after all. Even Motley Fool Champion Funds analyst Shannon Zimmerman has sung their praises. So why pick on them?

You might say they deserve it. Fellow Fool Selena Maranjian defined junk bonds best in The Motley Fool Money Guide: "A bond issued by a company with relatively high chances of defaulting." Exactly.

So, for instance, who cares if Bally Total Fitness (NYSE:BFT) 2011 bonds offer a 9.9% yield? The ailing gym operator is hoping to skirt a debt default by asking creditors for more time to file its financial statements. That hardly bodes well for the future, which means there may soon be nothing left to pay investors lured by the Siren call of apparent market-beating returns jammed into a meaty payout.

Junky dividends
The same thinking goes for stocks. Let's say that you go spelunking for stocks that pay a dividend yield of 3% or higher. You figure that with the market's average annual return of between 9% and 11%, you'll have a head start by getting paid almost one-third of your expected return in cold, hard moola. Sounds great, right? Not so fast.

Let's take a look at some of the best-paying income stocks on the market. Capital IQ finds 1,169 that yield at least 3%. Nice. But what happens when we bump the expected payout to at least 4%? 894 stocks remain. That still not enough yield for you? Fine, let's go for broke. There are more than 170 companies worth at least $100 million in market cap and also pay out 5% or more of their earnings in dividends.

Some of these yields look positively mouthwatering. Don't fall for it. You'd have to think dodging highway traffic is cheap entertainment to want to invest in stocks like these:

When free cash flow isn't free
Everything looks good until you get to the payout ratio. What is it? The payout ratio shows what portion of earnings is used for dividends, though it's often more Foolish to substitute free cash flow (FCF) for net income. Regardless, a lower ratio is better. Above 100% usually means the company isn't generating enough cash to pay shareholders their due.

Understand, too, that companies can take on debt to fund dividends. Take SureWest, for example. A check of its most recent quarterly filing shows that the firm had negative FCF through the first three months of the year. Accordingly, SureWest took on $3 million in short-term debt, likely to help fund $3.7 million in dividend distributions. That may work once, maybe even twice. But debt always has to be paid back, which says to me that SureWest's 5.6% yield is suspect.

Spy before you buy
More dangerous are the high yielders that look attractive in most respects but which face trouble that could cut or eliminate their dividends. Consider the case of Cherokee (NASDAQ:CHKE). The stock trades for 18 times trailing earnings, yields a very healthy 6.3%, and sports a breathtaking 69.8% return on capital over the trailing 12 months, according to Capital IQ. Pretty sweet, right?

Not exactly. I ran the stock through four tests for dividend payers recommended by Mathew Emmert, chief advisor for Motley Fool Income Investor. The results may surprise you:

• Show me the money. First, we want to know if Cherokee is able to pay its dividend using FCF. Not during 2005, it seems. The retailer paid out 102% of its FCF in dividends last year -- a far cry from peers such as Gap (NYSE:GPS) and Jones Apparel Group (NYSE:JNY), both of which have paid out less than 20% of FCF over the trailing 12 months. Strike one.
  
  
• Proven management team. Most of the management team, including CEO Robert Margolis, has been in place for most of the last decade. Also, management appears determined to keep its dividend commitment. Ball one.
  
  
• A noticeable yield. A 6.3% yield is a clear market-beater. I'd call that noticeable. Ball two.
  
  
• Reliable dividend track record. Cherokee only began paying dividends in 2004, and although it appears as though Cherokee will boost its dividend during fiscal 2007, its FCF doesn't inspire much confidence. Put simply, market-beating returns don't come from dividend-growth stocks with, uh, no dividend growth. Strike two.

Two balls and two strikes -- the situation isn't exactly clear-cut. Cherokee may reward investors, of course. Fellow Fool Ryan Fuhrmann makes an interesting bull case. But with dividend payouts equaling more than double FCF in the first quarter, it seems far more likely to me that today's meaty payout could be beef jerky tomorrow.

Naturally, I wish such situations were rare. They aren't. That's why Mathew regularly profiles at-risk dividend payers for Income Investor subscribers. A report uncovering these time bombs was recently made available. Get your copy by signing up for the service today. You'll also receive the Fool's second-annual blue-chip report, 10 Monster Stocks to Anchor Your Portfolio, as well as coverage of all of the stocks in the Income Investor portfolio, which has beaten the market by roughly four percentage points since inception. And that's before an average dividend yield that exceeds 4% as of this writing.

The Foolish bottom line
Most high-yield stocks are deceptively alluring. Don't be small-"f" fooled. Apply Mathew's tests, and pay attention to that pesky payout ratio. And most of all, remember: You may be able to profit from junk when it comes to bonds, but garbage rarely pays when it comes to stocks.

This article was originally published on July 16, 2004. It has been updated.

Fool contributor Tim Beyers is such a thrill seeker that he sits outside during thunderstorms. Occasionally, that is. Tim didn't own shares in any of the companies mentioned in this story at the time of publication. You can find out what is in his portfolio by checking Tim's Fool profile. Gap is a Stock Advisor and Inside Value recommendation.The Motley Fool has an ironclad disclosure policy.