The Next 2 Dividend Burnouts?

With the economy still shaky, many wary investors have been turning to the safety of dividend-paying stocks.

Investors poured $440 million into the Vanguard Dividend Appreciation ETF in February alone.

Buyer beware
While dividends provide a source of income that helps to smooth out market volatility, crises like the recent one are leaving many companies with little choice but to reduce or omit payments. According to data from Capital IQ, some 370 companies cut their dividends in 2008, and their stock prices had an average return of negative 56% for the year.

So how can you tell whether your company is about to make a cut? Last year, I argued that General Electric and Calumet Specialty Products were risking dividend cuts. (GE has since done so.)

Among the warning signs these companies exhibited:

• High yields.
• High payout ratios.
• Industry headwinds.

Extremely high yields indicate investors' skepticism that the company will be able to maintain its dividend. A high payout ratio -- particularly when combined with a difficult operating environment -- suggests that the company doesn't have enough free cash flow to support its payouts.

Bank of America (NYSE: BAC), for instance, was yielding nearly 8% in October 2008 when it had to suspend its dividend to preserve capital. While conditions for the bank are expected to improve, it's going to take several more years for the company to afford that $2.56 payout again, based on analyst earnings estimates.

But these factors don't necessarily imply that a cut is imminent. Many companies have continued to pay dividends they cannot afford for years, damaging their own companies -- and the value of your shares -- in the process.

I'll spare you all the details
A fascinating 2004 survey explains how and why. A team of four professors from Duke and Cornell surveyed more than 400 financial executives, discovering that 94% of executives "strongly ... or very strongly ... agree that they try to avoid reducing dividends." Many admitted to selling assets, laying off employees, borrowing heavily, or omitting important projects before cutting dividends.

See, these managers know that the market reacts negatively to dividend cuts. Several executives noted that Wall Street's response is an especially important consideration during liquidity crises, because they wouldn't want lenders to think that their company is struggling.

Such a fear may explain why even in a credit crunch, KeyCorp (NYSE: KEY) cut its dividend three times, apparently hoping each time that a limited cut would do the trick. It'll probably be years before the company can reinstate the dividend from its peak.

But let's get back to payout ratios. Unfortunately, if a company isn't generating enough free cash flow to support its payout, the extra cash has to come from someplace else. Aside from raising revenue or cutting spending, there are four basic ways a company can collect the cash it needs to make such payouts:

• Burn existing cash reserves.
• Borrow money.
• Issue shares.
• Sell assets.

While some of these practices may be acceptable bandages for a difficult year, none is sustainable over the long term. A company that pursues these strategies for too long will eventually burn itself out, damaging its shareholders in the process. Even worse, it's likely that the business will ultimately have to cut its dividend anyway.

So which companies might fit that description today?

Two companies risking a burnout
These two stocks have paid out more in dividends than they took in as free cash flow (or were free cash flow negative) over the past three years:

Data from Capital IQ, a division of Standard & Poor's.
*Calculated as total dividends paid minus free cash flow; trailing 24 months for Solar Capital, which has a shorter dividend history.

Student Loan Corp. continues to face millions in increased loss reserves and could be hurt by an end to federal subsidies to private student lenders.

Solar Capital is selling shares and ramping up its credit facilities even as it continues to pay out dividends in excess of the cash the business generates. I'm not necessarily claiming there's anything illegal going on, but it can't be taken for granted in this case that the board of directors will act to protect the interest of outside shareholders in setting dividend policy. Two of its largest stakeholders -- Magnetar and Goldman Sachs (NYSE: GS), who together own more than a quarter of the company -- have previously been accused of heavily shorting their own investments (Magnetar) and helping favored clients put together investments designed to fail so they can bet against them (Goldman).

The silver lining ...
Dividend stocks have a history of putting money in investors' pockets. However, choosing the right dividend stocks for a down market is critical to protecting your portfolio. Paying close attention to how your company funds its dividend will help you achieve the golden returns dividends offer.

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This article was originally published March 26, 2009, under the headline "The Next 3 Dividend Burnouts?" It has been updated.

Ilan Moscovitz is neither long nor short any companies mentioned in this article. The Motley Fool has a disclosure policy.