How to Avoid Dividend Disasters

Warren Buffett's right-hand man, Charlie Munger, likes to follow mathematician Carl Jacobi's advice to "invert, always invert."

In essence, this means that you start with the outcome you don't want, and work backwards from there. So, for instance, if you don't want to be a jerk, don't do things like call people stupid (oops).

For investors, it means starting with the investing outcome you don't want, and working backwards from there.

I'm a big fan of dividends; investors who focused on them over the past decade could have trounced the rest of the market. However, that doesn't mean that every dividend stock has performed admirably. So I thought I might put Munger's inversion advice to work on dividend stocks, to figure out what we should be avoiding.

Tracking down the duds
To find the dividend stinkers that we want to avoid, I dug up all of the companies that had a dividend yield of 2.5% or higher in 2000, and also lost money for investors -- on a dividend-adjusted basis -- between that starting point and today. I then began exploring reasons behind each individual stock's lackluster performance.

However, after spending a fair amount of time knee-deep in research, I found that my categorizations largely fell into just a handful of very familiar buckets. As it turns out, they were very similar to the dangers that value-investing godfather Ben Graham suggests investors beware in his classic tome, Security Analysis.

Just when you thought there was anything new in the markets, the reasons that underperforming stocks are stinking it up in the 21st century turn out to be exactly the same reasons why they stunk it up almost 70 years earlier.

Ben says "beware!"
Here are three of the investing red lights that Graham thinks should make investors stop dead in their tracks.

1. "The balance sheet [reveals] a poor current position, or funded debt is growing too rapidly"
My stack of underperforming dividend payers is littered with companies that we could put in this box. Used properly, debt can fuel growth and enhance shareholder returns. But when debt levels get out of hand, or the overall balance sheet starts deteriorating, the picture can get pretty bleak for shareholders.

The massive number of underperforming dividend-paying bank stocks could easily fall under this heading. From massive Bank of America (NYSE: BAC  ) to tiny PAB Bankshares (Nasdaq PABK), the banking industry fell prey to balance sheet issues. Most banks found themselves with rapidly deteriorating balance sheets, though some managed to supercharge their problems by also taking on huge amounts of leverage.

Not that this is a problem confined to the banks -- Foster Wheeler (Nasdaq: FWLT  ) and Rite Aid (NYSE: RAD  ) have also underperformed as they've wrestled with gnarly balance sheets.

2. "Dangerous new competition [is] threatening or ... the company [is] losing ground in the industry"
Ford (NYSE: F  ) , General Motors, and Chrysler. Need I say more? These once-venerable U.S. automakers could also be listed under No. 1 above, but while debt was a significant issue for each, lost ground to foreign automakers like Toyota did far more to set the stage for disaster.

Rite Aid can easily fit here as well. Though it may be hard to remember at this point, Rite Aid was once the big dog in the drugstore business. But the ground it lost to the dynamic duo of CVS (NYSE: CVS  ) and Walgreen (NYSE: WAG  ) contributed to terrible returns for Rite Aid's shareholders.

Investors can do well by tracking down industry leaders, but there are always up-and-comers gunning for the top spot. Thus, it's important to make sure the leader is doing what it needs to do to hold its ground.

3. "Reason to fear for the future of the industry as a whole"
Industry Armageddon. The mere thought of it should set investors' teeth rattling.

At the dawning of the Internet era, many venerable 20th century industries suddenly found themselves under attack from digitally dangerous upstarts.

In a world of digital pictures, traditional film suddenly started to look a heck of a lot like the proverbial buggy whip. For photographic kingpin Eastman Kodak (NYSE: EK  ) , that meant very bad things.

Ferris Bueller cautioned us that "life moves pretty fast." Sometimes the speed of life can bring changes that deal crushing blows to entire industries. To avoid portfolio bombs, investors need to stay aware and look out for these kinds of big shifts.

Not always the end of the road
Past offenders of these problem areas shouldn't necessarily be counted out forever. Foster Wheeler is in a much different position today than it was a decade ago, and now sports a notably strong balance sheet. Ford has similarly made an impressive turnaround, and it's been racking up market share gains.

But as long as a company is on the wrong side of one or more of these Grahamian pressure points, it's generally a good idea for conservative investors to keep their distance.

Want to see some dividend stocks that do work? Check out these five dividend growth stocks.