Dodging Dangerous Dividends

Editor's note: The original version of this article failed to include CharterMac's most recent quarterly results when calculating its payout ratio. It has since been updated. We regret the error.

Why do junk bonds have such an unattractive name? They can be great investments, after all. Even Motley Fool Champion Funds analyst Shannon Zimmerman has sung their praises. So why pick on them?

You might say they deserve it. Fellow Fool Selena Maranjian defined junk bonds best in The Motley Fool Money Guide: "A bond issued by a company with relatively high chances of defaulting." Exactly.

So, for instance, who cares if Delta Air Lines' (OTC BB: DALRQ) 2014 bonds offer a 6.4% yield? The bankrupt airline barely cobbled together a shaky agreement with its pilots and, in April, reported a decline in traffic. Neither bodes well for the future, which means there may soon be nothing left to pay investors lured by the Siren song of apparent market-beating returns jammed into a meaty payout.

Junky dividends
The same thinking goes for stocks. Let's say that you go spelunking for stocks that pay a dividend yield of 3% or higher. You figure that with the market's average annual return of between 9% and 11%, you'll have a head start by getting paid almost one-third of your expected return in cold, hard moola. Which sounds great, right? Not so fast.

Let's take a look at some of the best-paying income stocks on the market. Capital IQ finds 582 that yield at least 3%. Nice. But what happens when we bump the expected payout to at least 4%? The list falls to 389 stocks. That still not enough yield for you? Fine, let's go for broke. There are 276 companies that have more than $500 million in annual sales and also pay out 5% or more of their earnings in dividends.

Some of these yields look positively mouthwatering. Don't fall for it. You'd have to think dodging highway traffic is cheap entertainment to want to invest in stocks like these:

When free cash flow isn't free
Everything looks good until you get to the payout ratio. What is it? The payout ratio shows what portion of net income is used for dividends -- free cash flow (FCF) can be used instead of net income. A lower ratio is better. Above 100% usually means the company isn't generating enough cash to pay shareholders their due.

Understand, too, that companies can manipulate working capital to make their situation look better than it is. Take Regal Entertainment, for example. It managed to delay $180 million in bills due in the most recent quarter, which left more moola for dividends. That may work once, maybe even twice. But creditors don't like to be put off forever, which says to me that Regal's 5.8% yield is suspect.

Spy before you buy
More dangerous are the high yielders that look attractive in most respects but which face trouble that could cut or eliminate their dividends. Consider the case of Bristol Myers-Squibb (NYSE:BMY). The stock trades for less than 16 times trailing earnings, pays a very healthy 4.5% yield, and sports an 18.1% return on capital over the trailing 12 months, according to Capital IQ. Pretty sweet, right?

Not exactly. I know because I ran the stock through these four tests for dividend payers recommended by Mathew Emmert, chief advisor for Motley Fool Income Investor:

• Show me the money. First, we want to know whether Bristol Myers-Squibb is able to pay its dividend using FCF. Not during 2005, it seems. The pharmaceutical producer paid out 198% of its FCF in dividends last year -- a far cry from peers such as Novartis AG (NYSE:NVS) and Pfizer (NYSE:PFE), both of which paid out less than 45% of FCF. Strike one!
• Proven management team. Capital IQ shows that most of the management team, including CEO Peter Dolan, has been in place since at least 2001. Also, management appears determined to keep its dividend commitment. Call this one just off the corner. Ball one.
• A noticeable yield. A 4.5% yield is a clear market beater. I'd call that noticeable. Ball two.
• Reliable dividend track record. Uh-oh. While Bristol Myers-Squibb hasn't cut its dividend, the company hasn't been able to raise its payout since 2001. That's like a car with three wheels: You can try to drive if you like, but all you'll do is make noise as you go nowhere. Or, put differently, market-beating returns don't come to dividend growth stocks with, uh, no dividend growth. Strike two!

Two balls and two strikes -- not good odds, are they? Nope. Bristol Myers-Squibb may reward investors, of course. Legal wrangling over the patent for its Plavix blood thinner could turn in the company's favor. Or it may not. If it doesn't, today's meaty payout could be beef jerky tomorrow. That's why last year Mathew included Bristol Myers-Squibb in his inaugural profile of Dividend Time Bombs -- at-risk dividend payers.

To find out what other stocks make the Time Bomb list, click here for a free 30-day guest pass to Income Investor. You'll also gain access Mathew's complete list of recommendations -- a portfolio of dividend-payers that has beaten the market by roughly four percentage points since the newsletter's inception. And that's before an average dividend yield of more than 4% as of this writing.

The Foolish bottom line
Most high-yield stocks are deceptively alluring. Don't be small-"f" fooled. Apply Mathew's tests, and pay attention to that pesky payout ratio. Most of all, remember: You may be able to profit from junk when it comes to bonds, but garbage rarely pays when it comes to stocks.

This article was originally published on July 16, 2004. It has been updated.

Fool contributor Tim Beyers is such a thrill seeker that he sits outside during thunderstorms. Occasionally, that is. Tim didn't own shares in any of the companies mentioned in this story at the time of publication. You can find out what is in his portfolio by checking Tim's Fool profile. Pfizer is a Motley Fool Inside Value recommendation. The Motley Fool has an ironclad disclosure policy.