Dividend stocks may have a reputation of being safe or stodgy -- sometimes they're anything but.
For starters, the returns aren't safe or stodgy. According to Wharton professor Jeremy Siegel, fat-yielding Altria (NYSE: MO ) was the best S&P 500 stock from 1957-2003, followed by a slew of -- you guessed it -- high-yielding stocks.
But chasing long-haul riches with dividend stocks has a dark side. Consider the case of another iconic American company, Kmart. Kmart started the same year as Wal-Mart, reaching $1 billion in sales more than a decade more quickly than its rival. But over the years, Kmart stumbled. By the mid-1990s, the company wasn't even earning enough to cover its $0.96-per-share dividend payment. It wasn't long before Kmart cut its dividend -- and by January 2002, the company officially imploded into bankruptcy.
Shareholders of recent-dividend slashers Freddie Mac (NYSE: FRE ) and Fannie Mae can relate. Both companies' shares have been walloped over the past quarter and left legions of disappointed shareholders in their wake. The icing on the cake? Dividend cuts.
Spot the next implosion
See, dividend cuts and crushed stock prices go hand in hand. As such, you're probably wondering what you can do to avoid such an unprofitable fate. Scouting a company out for the following four warning signs will help you to quickly weed out the dividend time bombs in your portfolio.
1. Erratic earnings
Companies with inconsistent or cyclical earnings have broken the hearts of dividend lovers many times over. When times are good, management teams at lumpy-earnings firms often fool themselves into believing the profits are here to stay, and they confidently raise their payouts accordingly.
When the company's results revert back toward the mean, though -- usually because cyclical firms often have little pricing power, and their results are largely at the whim of uncontrollable market forces -- management painfully discovers it has bitten off more than it can chew. Avoiding choppy earnings streams is Step 1 for the dividend growth investor.
2. High or rising payout ratios
The same fat dividend that warms investors' hearts can sometimes give a company's management severe heartburn. Companies are loath to cut or suspend dividends, even when that option, however ugly, is clearly the best long-haul move for the firm. Managers know, with good reason, that dividend cuts and suspensions send the message that they do not think the firm will be able to maintain or continue growing earnings at a rate high enough to support their payouts.
It should be no surprise, then, that management is often willing to feign confidence by continuing to raise its payouts in the face of slowing or flat earnings growth. Management can work a little financial magic to help keep those dividends coming: adding leverage, issuing new shares, divesting assets, cutting salaries (not their own, of course!), etc. Payout ratios, though, particularly when based on cash flows, are tough to fake. If a company's dividend payments relative to its earnings and cash flows seem strangely higher than its peers', or if the ratio is continually creeping upward, a dividend cut could be in the cards.
3. Decelerating dividend growth rates
The is the first long-range sign that a long-growing company could fall flat on its face. Investors should take note when a company that has grown its dividend at a hearty clip over a multi-year period suddenly yanks back the reins and reduces the size of its dividend hikes.
There are plenty of reasons why such a move could make practical sense. The company could be shifting toward returning more money to investors through share repurchases, ramping up capital expenditures or research and development, or simply exhibiting prudent capital management.
Despite the many possible exceptions to this rule, you should know that dividend cuts are usually preceded by a deceleration in dividend growth. Keep an eye on the size of the dividend increases of the stocks in your portfolio.
4. The sniff test
Even if you've cleared those three hurdles, pause and ask yourself this question before pulling the trigger on a stock: Do I really understand how this company makes money? If you can't quickly and confidently answer that question, you should avoid investing in the company in question. Period.
Peter Lynch said to never invest in any idea you can't illustrate with a crayon. If I tried to draw Fannie or Freddie's business model with a crayon, it would look like a pre-schooler's take on Kandinsky. The same could be said of former highfliers and dividend-divers Doral Financial (NYSE: DRL ) or NovaStar Financial (NYSE: NFI ) , whose seemingly too-good-to-be-true results turned out to be just that. If you don't understand how money flows through a company, move on to the next idea.
The good news!
But hey, let's stay positive here. While there are plenty of dividend traps out there, you'll be able to avoid most of them by focusing on the above four warning signs.
Better yet, you can find great investments by scouting out firms on the opposite side of the coin. Companies sporting similarly healthy long-run earnings and dividend growth, including Anheuser-Busch, Diageo (NYSE: DEO ) , and Home Depot (NYSE: HD ) , recent bumps aside, typically offer up stellar long-run returns.
Dividend growth investing isn't sexy, but it is a proven market-beating strategy. The Fool has delivered its own market-beating returns with its Motley Fool Income Investor newsletter, to which I was a charter subscriber. To learn about the service's top five dividend-paying ideas for new money, try it free for 30 days.
This article was originally published June 8, 2007. It has been updated.
Joe Magyer does not own shares of any companies mentioned in this article. Diageo is an Income Investor recommendation, while Home Depot, Wal-Mart, and Anheuser-Busch are Inside Value recommendations. Fannie Mae is a former Inside Value recommendation. The Motley Fool has a disclosure policy.