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.

That'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 Nokia (NYSE: NOK  ) and HSBC (NYSE: HBC  ) 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.

Before Harley-Davidson reduced its quarterly dividend from $0.33 to $0.10 earlier this year, the stock was "yielding" 10%. And when yields are high and investors still aren't buying, it's worth considering why other investors may be 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, leading to dividend cuts or suspensions.

When discretionary consumer spending came crashing to a halt in late 2008, the automakers were particularly hurt. Even more-successful automakers like Honda (NYSE: HMC  ) and Toyota (NYSE: TM  ) joined Ford (NYSE: F  ) and soon-to-be-bankrupt General Motors in cutting their dividends.

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.

Procter & Gamble, a diversified consumer-staples maker that is largely shielded from economic cycles, has paid an uninterrupted dividend since 1890. By contrast, Whole Foods (Nasdaq: WFMI  ) paid its first dividend in 2004 -- and, owing to industry headwinds, suspended its payments in August 2008.

Of course, when history meets headwinds, sometimes the headwinds prevail. Despite more than 30 years of consecutive dividend increases under its belt, Bank of America (NYSE: BAC  ) proved unable to shield itself from the industry headwinds this time around, and it had to cut its quarterly dividend to $0.01 in accordance with its bailout terms.

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 greater than 80%, or negative free cash flow.

Two companies risking a blowup
So which companies will likely be the next dividend blowups? According to the above criteria, possibly these two:

Company

Yield

FCF Payout Ratio

Industry

Duke Energy

6.1%

N/A (negative FCF)

Electric Utilities

Frontline

4.4%

209%

Oil & Gas Storage and Transportation

Data from Yahoo! Finance and Capital IQ, a division of Standard & Poor's.

Their yields are moderately high, 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.

Duke Energy's earnings are down 35% over the past 12 months, largely because of lower demand for electricity from industrial customers hurt by the recession. The company is committed to spending billions on new coal and wind projects that it says will generate high returns. But with more than $15 billion in net debt and more than $1.6 billion free cash flow shortfall, the utility may choose to lighten up its hefty payouts for the time being.

Frontline's managers insisted that cutting the company's dividend from $3 last September to $0.50 "does not in any way constitute a shift in Frontline's dividend strategy." This Fool found it hard to agree with them. Fast-forward several months, and that dividend is now $0.25. The company is trying to conserve cash amid increasing expenditures, a weak 2009 environment, and the credit squeeze.

None of these factors looks 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.

If you'd like to see the dividend payers our team at Motley Fool Income Investor likes, including their 10 best bets for new money now, you can try the service free for 30 days. Click here for all the details -- there's no obligation to subscribe.

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

Ilan Moscovitz owns shares of Whole Foods, a Stock Advisor recommendation. Procter & Gamble and Duke Energy are Income Investor selections. Nokia is an Inside Value pick. The Fool owns shares of Procter & Gamble. The Motley Fool has a disclosure policy.


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