These Dividends Are Done

It's been a scary year for dividend investors.

Even with the recent rally, dividend yields are sky-high. According to Capital IQ, there are 1,126 stocks on our major exchanges with yields of 5% or more. But many of these are dividend traps, enticing us with the promise of fat quarterly payouts, only to cut them down the road.

As a stark reminder, we can look to General Electric. Once hailed as the safest of the safe, GE has in short succession received government help, cut its dividend to save cash and (hopefully) retain its AAA debt rating, and then lost that AAA status anyway.

More examples abound, from Pfizer (NYSE: PFE  ) to Motorola (NYSE: MOT  ) to Citigroup (NYSE: C  ) and the rest of the big banks.

The "5% of nothing" club
Traditionally, a 5% dividend yield has been eye-popping enough to elicit fears of a dividend cut. Now, it feels commonplace. When you see a blue chip like Kraft creeping up on a 5% yield, anything short of double digits starts to feel safe. And we start getting a little greedy.

But that greed can turn right back into fear if the great double-whammy curse of high-yielding stocks kicks in. After all, we buy dividend stocks because they provide a large, steady stream of income and have the promise of stock price appreciation. But then:

  • In this environment, a susceptible high-yielding company's share price takes a beating. (Whammy!)
  • To preserve precious capital, said company cuts or altogether eliminates its dividend, destroying dreams in the process. (Double-whammy!)

As a result, I view any dividend yield as a "too good to be true" situation until I've fully vetted the company. It's a good default stance on any stock you're considering buying. Let's take a quick look at some companies with 5%-plus dividends:

Company

Dividend Yield

Payout Ratio

Vodafone (NYSE: VOD  )

5.7%

130%

World Wrestling Entertainment (NYSE: WWE  )

10.2%

167%

Total (NYSE: TOT  )

5.5%

76%

Bristol-Myers Squibb (NYSE: BMY  )

5.6%

45%

Horizon Lines

6.9%

Negative

Source: Capital IQ (a division of Standard and Poor's).

The story behind the numbers
The first thing I do when I see a tasty dividend is look for obvious problem areas. If I can spot a major problem quickly, it saves me further research.

Notice the payout ratios (the percentage of earnings a company pays out in dividends) in the table above. If I see a payout ratio greater than 50%, I get suspicious. When the payout ratio goes above 100%, that means dividends aren't currently being covered by earnings.

Worse than a payout ratio greater than 100% is one that is negative -- that is, the company is paying out dividends despite reporting a loss.

So while I would certainly look closely at the quality of earnings of the three companies with payout ratios above 50% before investing in their stocks, I would be even more skeptical of the dividend sustainability of Horizon Lines, which has a negative payout ratio.

Now, keep in mind that the payout ratio is just one metric. It's certainly useful for screening purposes, but further research fills in the picture. For instance, those making the bull case for Horizon Lines would point to the company's positive free cash flow as evidence of dividend sustainability.

Which dividends will survive?
It's darn hard to determine the sustainability of dividends in this environment. Due diligence is important in any environment, but it's especially important now, when we can scoop up high-dividend plays that could form the core of our portfolios for decades to come.

The folks at our Income Investor newsletter do their homework. They look for the most stable companies that pay the highest, most sustainable dividend yields. They actually recently took Kraft off their list of recommendations, not because it's a bad company, but because they see better opportunities out there.

For new money, they rank six sustainable dividend-paying stocks as "buy first" candidates. You can see all six, and try out the entire service, for free with a 30-day trial. Click here to learn more -- there's no obligation to subscribe.

Already subscribe to Income Investor? Log in at the top of this page.

This article was originally published May 7, 2009. It has been updated.

Anand Chokkavelu owns shares in Pfizer and Citigroup. In his spare time, he hosts a snack-food program called These Doritos Are Done. Pfizer is a Motley Fool Inside Value selection. Total SA is an Income Investor recommendation. The Fool has a disclosure policy.


Read/Post Comments (5) | Recommend This Article (14)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 18, 2009, at 8:19 AM, pondee619 wrote:

    What is a negative payout ratio?

  • Report this Comment On September 18, 2009, at 8:43 AM, frtedcrilly wrote:

    Great article, still holding VOD in Uk, though I sold the US ones, after a surprisingly large payout! great guidance as divi stocks are boring reliables if you avoid the thin ice! So many more could be discussed, and you have encouraged me to take on another Motley Fool service, income investor. Your MDp portfolio has returned me 50% in 4 months...one very happy Fr. Ted Crilly!

  • Report this Comment On September 18, 2009, at 9:36 AM, andevenabs wrote:

    BMY with a 45% payout ratio and a low debt to capital ratio is a dividend cut candidate?

    If you ask me, you should replace BMY with KFT which has an enormous debt load and considering a major acquisition.

  • Report this Comment On September 18, 2009, at 3:20 PM, TMFEditorsDesk wrote:

    @pondee619,

    You get a negative payout ratio when there are negative earnings (which is the denominator in the payout ratio...numerator is divends per share)

    @andevenabs,

    That list is simply a sample list of companies with dividends above 5%...it isn't a red flag based on the payout ratio since it comes in under 50%. Again, that's just one metric.

    -Anand (TMFBomb)

  • Report this Comment On December 02, 2009, at 4:07 PM, bigbadellie wrote:

    The dividends for Allstate has been sinking. Yet, they sponsor one commercial after another on TV.

    Morgan Stanley stock holders have been short changed with their dividends also.

    What do the ceo's and cfo's get in the way of compensation while the investors, many of them seniors, have had their dividends cut.

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