Woolworth's was a company with a rich history. Founded in 1879 by entrepreneur Frank Woolworth, the five-and-dime store was a precursor to the retail behemoths that dominate the commercial landscape today -- Target (NYSE:TGT), Wal-Mart (NYSE:WMT), and Kmart, to name a few. By 1911, the firm operated more than 500 stores, and in 1913, Woolworth constructed the Woolworth Building in New York City. At the time, it was the tallest building in the world. The company had the makings of an empire.
Fast-forward to 1997. Woolworth's was out of business -- though a portion of it survives as Foot Locker (NYSE:FL) -- and Wal-Mart had booted it from the Dow. For investors on autopilot, it was a very rude awakening.
What happened?
The main culprit behind Woolworth's demise was competition. But suffice it to say, management sat on its hands as the business deteriorated beyond repair. One of the reasons for the destruction? Dividends.
"Dividends?" you're shouting in disbelief. "It can't be! Dividends are our friends."
But in Woolworth's case, they were crucial to the company's undoing. With the company struggling, management insisted on continuing to pay its dividend even though earnings did not support the practice. The reason: They wanted to appease longtime blue-chip investors. In order to find the cash to pay the dividends, Woolworth's assumed debt, then more and more of it. Finally, it was just too much. The company was forced to slash its dividend, but by then, the end was near. A company that had been part of America's consciousness and the site of the famous Greensboro, N.C., civil rights sit-in was finished -- leaving empty stores, broken investors, and out-of-work Americans in its wake.
So how can investors tell whether their dividend payer is the Johnson & Johnson (NYSE:JNJ) type with a solid, rising dividend or of the unsustainably Woolworthian sort?
Consider this a warning
On the surface, ConAgra Foods (NYSE:CAG) is the kind of company that makes dividend investors drool. It's not terribly flashy or high growth, but by focusing on the prepackaged-food business, ConAgra has the stuff of such solid long-term performers as Kraft (NYSE:KFT) and Pepsi (NYSE:PEP).
But ConAgra's 4.7% dividend yield isn't worth the current price of admission. While I can't predict if or when ConAgra will cut its dividend, I wouldn't be surprised if it did.
Go with the cash flow
ConAgra's dividend isn't fully funded by its free cash flow (FCF); its payout ratio -- based on FCF -- over the first 39 weeks of this year and the previous two fiscal years has come in at 109%, 234%, and 170%, respectively. ConAgra is also laying out additional cash for debt repayments and share repurchases. Although its current 109% payout ratio is an improvement over past years, any ratio greater than 100% in combination with slumping sales and sluggish profits is a recipe for disaster.
One key to finding dividend performers (and dividend payers are performers, having outrun their non-dividend-paying counterparts in the S&P by a compounded rate of more than 3% in each of the past 25 years) is to look for companies that pay out less than 60% of FCF, utilities that pay out less than 75% of FCF, and REITs that pay out less than 85% of funds from operations (FFO). These are sustainable dividends that will be rising long enough to enhance the returns of you, your children, your grandchildren, your great grandchildren ... you get the point.
Find superior dividends
Master dividend investor John Neff guided his Windsor Fund to market-beating returns by finding superior dividends that rose year after year. After all, he learned from Graham and Dodd that yield is the most assured part of growth.
At Motley FoolIncome Investor, lead analyst Mathew Emmert scours the market to find today's superior dividends. Conservative payout ratios are one criterion he uses to identify these opportunities. To date, he's scored a 17.3% cumulative return on the back of recommendations such as RPM International (NYSE:RPM), which has rewarded investors in little more than a year with 37.2% returns and still offers a compelling 3.2% yield. To view Mathew's four dozen more superior dividend payers, try a 30-day free trial to the newsletter. You'll enjoy access to all the back issues and previous picks, the current risk-adjusted values, and to the Income Investor discussion boards, where Mathew posts regularly and where like-minded investors share their ideas and analyses.
Foolish final words
Surprisingly, it's often not the size of the dividend that matters but the quality. Staying on top of how your company funds its dividend and its underlying business prospects isn't simple, but that's the way to keep your dividends and portfolio rising for generations.
Nathan Parmelee has no financial stake in any of the companies mentioned. The Motley Fool has an ironclad disclosure policy.
