Avoid the Next Dividend Implosion

Dividend stocks may have a reputation for being safe or stodgy, but sometimes they're anything but. For starters, the returns aren't safe or stodgy. According to Wharton professor Jeremy Siegel, fat-yielding Altria was the best stock from 1957-2003, followed by a slew of -- you guessed it -- high-yielding stocks.

But chasing long-haul riches with dividend stocks has a dark side. Consider the case of another iconic American company, Kmart. Kmart started the same year as Wal-Mart and reached $1 billion in sales more than a decade faster than its rival. But Kmart stumbled. By the mid-1990s, the company wasn't even earning enough to cover its $0.96-per-share dividend payment. It wasn't long before Kmart cut its dividend -- and by January 2002, the company officially imploded into bankruptcy.

Their losses may be less dramatic, but anyone who has owned shares in dividend slashers Pier 1 (NYSE:PIR) or Fannie Mae (NYSE:FNM) can reiterate that a company's share price and dividend typically share the same fate. The relationship between the two is clear, particularly on the downside:

These negative returns are all the worse considering that the S&P 500 has returned roughly 40% over the same time period.

Because decreased dividends and stock prices go hand in hand, you're probably wondering what you can do to avoid such an unprofitable fate. Screening a company's financials for three warning signs will help you quickly weed out the dividend time bombs in your portfolio.

1. Erratic earnings
Companies with inconsistent or cyclical earnings have broken the hearts of dividend lovers many times over. When times are good, management teams at lumpy-earnings firms often fool themselves into believing the profits are here to stay, and they confidently raise their payouts accordingly.

When the company's results revert back toward the mean, though, usually because cyclical firms often have little pricing power and their results are largely at the whim of uncontrollable market forces, management painfully discovers it has bitten off more than it can chew. Avoiding erratic earnings streams is step one for the dividend growth investor.

2. High or rising payout ratios
The same fat dividend that warms the heart of investors can sometimes give a company's management severe heartburn. Companies are loath to cut or suspend dividends even when that option, however ugly, is clearly the best move for the firm in the long haul. Managers know, with good reason, that dividend cuts and suspensions send the message that they do not think the firm will be able to maintain or continue growing earnings at a rate high enough to support their payout.

It should be no surprise, then, that management is often willing to feign confidence by continuing to raise their payouts in the face of slowing or flat earnings growth.

Management can work a little financial magic to help keep those dividends coming: adding leverage, divesting assets or subsidiaries, cutting salaries (though not their own, of course), etc. Payout ratios, though, particularly when based on cash flows, are tough to fake. If a company's dividend payments relative to its earnings and cash flows seem strangely higher than its peers, or if the ratio is continually creeping upwards, a dividend cut could be in the cards.

3. Decelerating dividend growth rates
The last quick check also happens to be the first long-range sign that a long-growing company could fall flat on its face. Investors should take note when a company that has grown its dividend at a hearty clip over a multi-year period suddenly yanks back the reins and reduces the size of its dividend hikes.

Now, there are plenty of reasons why such a move could make practical sense. The company could be shifting toward a policy of returning more money to investors through share repurchases, ramping up capital expenditures or research and development, or simply exhibiting prudent management.

Despite the many possible exceptions to this rule, though, you should know that dividend freezes or cuts are usually preceded by a deceleration in dividend growth. Keep an eye on the size of the dividend increases of the stocks in your portfolio.

The good news!
Fear not, Fools. While there are plenty of dividend traps out there, you'll be able to avoid most of them by focusing on the above three warning signs.

Better yet, you can find great investments by scouting out firms on the opposite side of the coin. Companies sporting consistent payout ratios and earnings growth like the ones below fatten the wallets of easy-resting shareholders.

Dividend growth investing isn't sexy, and you aren't likely to wow friends at cocktail parties with your latest investment in Genuine Parts. Still, through patience and careful due diligence, you'll find the approach can handily yield market-beating returns with below-market volatility.

That's what the Fool has delivered with its Motley Fool Income Investor newsletter service. Over the past four years, the average Income Investor stock recommendation is beating the S&P 500 by 5 percentage points. If you're interested in this low-volatility, high-return strategy and want our top five stock ideas for new money, we're offering a 30-day free trial.

This article was originally published on June 8, 2007. It has been updated.

Fool editor Joe Magyer does not own any stocks mentioned in this article. Bank of America is an Income Investor recommendation. Fannie Mae and Wal-Mart are Inside Value recommendations. The Motley Fool has a disclosure policy.