The Next 2 Dividend Blowups?

You may have heard that dividend stocks have significantly outperformed their stingier counterparts since 1972. You may have heard that the vast majority of the market's historical gains have come from dividends. And you may have heard that they are the best stocks to own during bear markets.

It's all true. In fact, during market downturns dividend stocks outperform by as much as 1% to 1.5% per month.

But before you dive in and start buying dividend stocks, there's something you need to know.

Hold your horses
Dividend payers aren't all gumdrops and rainbows, as shareholders of dividend-slashers First Horizon and SunTrust know all too well.

138 companies cut their dividends during the third quarter, the biggest quarterly decline since 1991, for a grand total of $22 billion in skipped payments. Fully 374 companies reduced their dividends in 2008. Their average performance during that time frame? Negative 57%.

To avoid the next dividend implosion, you've got to keep an eye on a dividend payer's overall strength -- and its ability to pay those vaunted dividends. So as you're looking for dividend stocks for a bear market, keep an eye out for these red flags:

• Extremely high yield
• Industry headwinds
• Spotty track record
• High payout ratio

Extremely high yield
A yield that seems too good to be true usually is. An extraordinarily high yield is tempting, but such yields tend to come about when a stock has been beaten down -- which means investors don't have confidence in it.

When National City (NYSE:NCC) first cut its dividend in half one year ago in response to the subprime crisis, the stock was "yielding" 12%. After cutting its dividend to one cent in October, the company eventually agreed to sell itself in a fire sale to PNC Bank.

And when yields are high and investors still aren't buying? It's worth considering why other investors are wary of those tantalizing yields.

Industry headwinds
If an industry comes under attack -- as happens in cyclical industries and during economic crises -- there may not be any earnings to distribute, and dividend cuts or suspensions often follow.

One of the major unknowns right now is whether major inflationary factors, such as geopolitical risk, rising demand from emerging economies, and limited supply, will lead to a sustained period of rising energy prices, or whether this economic downturn will continue to keep prices low.

Investors looking to collect dividends over the next several decades from cyclical industries like energy may want to consider that, of all the S&P 500 members of the energy sector -- a group that includes such varied stalwarts as Tesoro (NYSE:TSO), Halliburton (NYSE:HAL), and XTO (NYSE:XTO) -- only one, ExxonMobil, has managed to raise its dividend for 25 consecutive years.

Spotty track record
Companies that have a checkered history of dividend payments aren't the strongest candidates for investment -- especially in a bear market, when external factors may strain their resources. Companies with a long and steady history of dividend increases, on the other hand, have demonstrated their reliability and are less likely to expose their investors to massive losses.

Intel (NYSE:INTC), a diversified consumer staples maker largely shielded from economic cycles, has been raising its dividend since it was first instituted in 1992. By contrast, luxury grocer Whole Foods paid its first dividend in 2004 -- and, as a result of industry headwinds, is now suspending its payments.

Of course, when history meets headwinds, sometimes the headwinds prevail. Despite more than 25 years of consecutive dividend increases under its belt, Fifth Third Bancorp proved unable to shield itself from the industry headwinds this time around and had to cut its dividend earlier in the year.

High payout ratio
A company's payout ratio -- usually calculated as dividends divided by net income -- is one of the most commonly used metrics to determine whether it can afford to continue paying its dividend at the same rate. A high payout ratio suggests that a company is returning the vast majority of its earnings to shareholders and therefore may not have enough left over to fund future operations -- risking cut or suspended payments down the line.

Another good metric is free cash flow. Net income is an accounting construction that captures the gist of a company's operations, but it doesn't reflect how much cash a company actually has left over from its operations to cut your check.

Consider ruling out companies with a ratio above 80% or which are free cash flow negative.

Two companies risking a blowup
So, all that being said, which companies are likely to be the next dividend blowups?

According to the above criteria, these two might be next:

Data from Capital IQ.

Their high payout ratio (Dow) and negative free cash flow (Huaneng) suggest their yields are unsustainable for lack of ready cash. And they're facing other problems as well.

Dow announced in December that it would be closing 20 plants and cutting its workforce by 5,000 employees in an effort to control costs in a recessionary environment that is hurting demand for Dow's chemicals. On top of that, the company is on the hook for the entire $15 billion price tag of Rohm & Haas after its partner in the attempted acquisition bowed out. Dow's doing its best to secure financing, which has been made more difficult by rating cuts, and every month the company delays it gets dinged another $100 million.

Even if we disregard Huaneng Power's capital expenditures -- which are a whopping 10 times its operating cash flows -- its dividend payout is still twice that same operating cash flow. Huaneng Power may be a great company, but payouts of that magnitude are simply unsustainable, particularly in an environment where higher coal costs will prevent the company from earning a profit in 2008.

The silver lining ...
Dividend stocks have a history of putting money in investors' pockets, but choosing the right dividend stocks for a down market is critical to protecting your portfolio. Considering these warning signs of an unsustainable dividend will help you to achieve those golden returns dividends have to offer.

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This article was first published Aug. 25, 2008. It has been updated.

Ilan Moscovitz owns shares in Whole Foods, a Motley Fool Stock Advisor recommendation. Intel is an Inside Value selection. The Fool has written covered calls on Intel, an Inside Value selection. Huaneng Power is a Rule Breakers and Income Investor pick. The Motley Fool owns shares of Intel as well as covered calls on Intel. The Motley Fool has a disclosure policy.