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 recent dividend-slashers know all too well.
Fully 374 companies reduced their dividends in 2008, for a grand total of $46 billion in skipped payments. 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 first cut its dividend last year 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.
And when yields are high and investors still aren't buying? It's worth considering why other investors are wary of those tantalizing yields.
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 over 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’s (Nasdaq: INTC ) scale advantage over Advanced Micro Devices (NYSE: AMD ) has given it the stability to raise 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, suspended its payments last year.
Of course, when history meets headwinds, sometimes the headwinds prevail. Despite nearly 100 years of maintaining or raising its dividend under its belt, Dow Chemical (NYSE: DOW ) proved unable to shield itself from the industry headwinds this time around and had to cut its dividend last 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:
FCF Payout Ratio
DuPont (NYSE: DD )
Oil and Gas Transportation
Data from Yahoo! Finance and Capital IQ, a division of Standard & Poor's.
Their yields range from moderately high (Frontline) to high (DuPont), while their free cash flow payout ratios suggest they may not be able to afford those payouts. And they're facing other problems as well.
DuPont is facing tough headwinds as builders, automakers, and consumer goods producers cut back on chemical orders. Yesterday, the company announced a 48% decline in quarterly earnings (excluding restructuring charges), which sounds pretty bad, though it gets worse when you consider that the company was only able to achieve that through cost-cutting.
The company is slashing jobs and capital expenditures, though it’s unlikely to produce nearly enough free cash flow to support its dividend even if it manages to meet its somewhat optimistic earnings goals and planned capital expenditure reductions.
While Frontline's management insists that cutting its dividend from $3 to $0.50 last September "does not in any way constitute a shift in Frontline's dividend strategy," it's hard to see it as anything but. Fast-forward several months and that dividend is now $0.25. The company is trying to conserve cash due to increasing expenditures, a weak 2009 environment, and the credit squeeze.
None of these factors look likely to change, and analysts expect earnings to decline more than 80% this year. Given Frontline's high payout ratio and capital-intensive business, an actual strategic shift could make sense.
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 of Whole Foods, a Motley Fool Stock Advisor recommendation. Intel is an Inside Value selection. The Fool owns shares of XTO. The Motley Fool has a disclosure policy.