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 First Horizon (NYSE:FHN) and UBS know all too well.

In 2009, S&P 500 companies skipped a record $52.6 billion in dividend payments. 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 materialize when a stock has been beaten down -- which means investors don't have confidence in it.

When National City announced its first dividend cut last January, for example, the stock was "yielding"10%. Since then, the stock plunged, and the company agreed to be acquired by PNC (NYSE:PNC).

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.

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 varied stalwarts such as Valero (NYSE:VLO), National Oilwell Varco (NYSE:NOV), and Chesapeake Energy (NYSE:CHK) -- only one, ExxonMobil, has managed to raise its dividend for more than 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.

Procter & Gamble (NYSE:PG), a diversified consumer staples maker largely shielded from economic cycles, has paid an uninterrupted dividend since 1890, and has raised it for 53 consecutive years. By contrast, luxury grocer Whole Foods paid its first dividend in 2004 -- and, as a result of industry headwinds, had to suspend its payments in 2008.

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 woes this time around and had to cut its dividend.

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 those with 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:

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

While their yields are only moderately high, Chemical Mining's free cash flow payout ratio and GATX's lack of free cash flow suggest they may not be able to afford those payouts. And they're facing other challenges as well.

Like many foreign companies, Chemical Mining's dividend can vary somewhat depending on net income. Still, the company isn't generating nearly enough free cash flow to maintain the heightened level it paid out last year.

While GATX's rail fleet remains booked, lease rates are declining, and marine rates remain depressed. The company's CEO noted that "markets remain extremely challenging and competitive," and that pricing pressure will remain in force at least through 2010.

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, which, along with National-Oilwell Varco, is a Stock Advisor recommendation. Procter & Gamble is an Income Investor selection. Chesapeake Energy is an Inside Value pick. The Fool owns shares of Chesapeake and Procter & Gamble and has a disclosure policy.