Avoid the Dividend Trap

• Email
• Share
• Print

Have you ever had the dividend cut on one of your stocks, seemingly out of the blue?

Perhaps you spotted a company shelling out a juicy 8% yield and thought to yourself, "Hey, even if the stock's share price doesn't move this year, I'll still make 8%." It's certainly a tempting proposition.

But this, my friends, is the dividend trap. In many cases, there's a reason why the company has such a high yield -- and it's a bad one for prospective investors.

Feel the pain
Hey, I fell into the trap with Education Realty Trust, and it's not a pleasant experience. In a flash, your expected returns are reduced, and you're left banking on the hope that management will be able to do more with that cash they're preserving than you could. Some investors in General Motors (NYSE: GM), Ford (NYSE: F), and Friedman Billings Ramsey (NYSE: FBR) know the feeling -- each of these companies has slashed their dividends in recent years.

But I should have known better. After all, there were numerous warning signs I should have noticed to avoid the trap, and I missed just about all of them.

There's a better way
Instead of wondering if companies are financially healthy enough to make their dividend payments each quarter, I've resolved to look for companies that actually have room to grow their dividends.

A good rule of thumb is to look for companies that pay out less than 80% of free cash flow and have a long track record of increasing dividend payouts.

These are some of the very qualities that Fool senior analyst James Early and his Income Investor service look for when recommending good dividend-paying stocks to subscribers.

Here are three stocks that meet these criteria:

• Procter & Gamble (NYSE: PG) has a long track record of increasing its dividends while maintaining double-digit earnings growth -- not an easy feat for any company. Over the past five years, for instance, P&G earnings per share have grown 21% on average. Dividend payments have followed suit, growing 11% on average over the same period.

• UST (NYSE: UST), manufacturer of smokeless tobacco products Skoal and Copenhagen, has an attractive 3.9% yield and a history of growing dividends. The biggest threat to the company's future bottom line is the same threat that plagues other tobacco producers, such as Reynolds American (NYSE: RAI): lawsuits and litigation expenses.

• Willis Group Holdings (NYSE: WSH) is a U.K.-based insurance broker that can trace its roots back to 1828. It boasts a 2.3% yield and has strong operating margins and revenue growth.

Common ground
None of these companies is a current Income Investor recommendation, but each looks more than capable of paying its current dividend payments and increasing them for years to come. In other words: no dividend traps in sight.

If you'd like to see all of the official Income Investor picks, click here for a 30-day free trial. There is no obligation to subscribe. Since its inception, Income Investor is beating the market by seven percentage points, and the average yield of the companies it has recommended is more than 4%.

Todd Wenning owns shares of Education Realty Trust. The Fool's disclosure policy is as cool as the other side of the pillow.