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 dividend payers 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 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 show up 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 last year, the stock was "yielding" 10%. 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, 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 axing their dividends. Although Ford could probably afford to reinstate its $0.40 dividend now (it would yield about 3% at today's prices), and Honda soon, it might take Toyota until 2013 or so until it could afford to pay out what it did in 2008.

Spotty track record
Companies with 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, lowered capital expenditures and suspended its payments in August 2008. The company is weathering the economic storm quite well. With cash flow growing to an all-time high, could afford to reinstate its payouts should it decide to do so.

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.

While the company has repaid its bailout money, and its 8.2% Tier 1 capital ratio suggest the bank is well capitalized, a difficult residential and consumer loan market make it unlikely the bank will return to its former level of profitability any time soon.

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 dividends divided by 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:

Company

Yield

FCF Payout Ratio

Industry

Huaneng Power (NYSE: HNP  )

5.2%

N/A

Electric Utilities

Vector Group (NYSE: VGR  )

9.8%

274%*

Cigarettes

Data from Yahoo! Finance and Capital IQ, a division of Standard & Poor's. *Excludes certain one-time charges and gains.

Their yields are quite high, and their free cash flow payouts suggests they may not be able to afford those payouts.

For years, Huaneng Power has operated with a cash flow deficit in order to finance expansion while it continued to pay a hefty dividend.

While the tobacco industry is known for its reliability, Vector Group, the maker of Liggett cigarettes, pays out significantly more cash than it takes in.

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 that dividends have to offer.

If you'd like to see the dividend payers our team at Motley Fool Income Investor likes, including its six Buy First stock ideas, 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. Ford Motor and Whole Foods Market are Motley Fool Stock Advisor choices. Procter & Gamble is a Motley Fool Income Investor pick. The Fool owns shares of Procter & Gamble. The Fool has a disclosure policy.


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