The Next 2 Dividend Blowups?

You may have heard that dividend stocks have significantly outperformed their stingier counterparts since 1972. You may have heard that the vast majority of the market's historical gains have come from dividends. And you may have heard that they are the best stocks to own during bear markets.

It's all true. In fact, during market downturns dividend stocks outperform by as much as 1% to 1.5% per month.

But before you dive in and start buying dividend stocks, there's something you need to know.

Hold your horses
Dividend payers aren't all gumdrops and rainbows, as shareholders of dividend-slashers Citigroup (NYSE:C) and Washington Mutual (NYSE:WM) know all too well.

Nearly 100 companies cut their dividends during the second quarter, the biggest quarterly decline since 1991, bringing the total number of companies that have cut their dividends in the last year to 200. Their average performance during that time frame? Negative 44%.

To avoid the next dividend implosion, you've got to keep an eye on a dividend payer's overall strength -- and its ability to pay those vaunted dividends. So as you're looking for dividend stocks for a bear market, keep an eye out for these red flags:

• Extremely high yield
• Industry headwinds
• Spotty track record
• High payout ratio

Extremely high yield
A yield that seems too good to be true usually is. An extraordinarily high yield is tempting, but such yields tend to come about when a stock has been beaten down -- which means investors don't have confidence in it.

When Wachovia (NYSE:WB) announced last month that it would cut its dividend, for example, the stock was "yielding" 10.5%.

And when yields are high and investors still aren't buying? It's worth considering why other investors are wary of those tantalizing yields.

Industry headwinds
If an industry comes under attack -- as happens in cyclical industries and during economic crises -- there may not be any earnings to distribute, leading to dividend cuts or suspensions.

With discretionary consumer spending crashing to a halt, July auto sales fell to their lowest level in 16 years. The hurt isn't restricted to U.S. auto makers -- even hugely successful competitor Toyota reported double-digit sales declines last quarter.

And it's only going to get worse. Ford (NYSE:F) marketing chief Jim Farley said he "expects the second half of 2008 will be more challenging than the first half as economic and credit conditions weaken."

Amid that ugly backdrop, General Motors (NYSE:GM) joined Ford in axing its dividend.

Spotty track record
Companies that have a checkered history of dividend payments aren't the strongest candidates for investment -- especially in a bear market, when external factors may strain their resources. Companies with a long and steady history of dividend increases, on the other hand, have demonstrated their reliability and are less likely to expose their investors to massive losses.

General Electric, the abiding example, has raised its dividend for 32 consecutive years and has paid a dividend every quarter since 1899. By contrast, Whole Foods (NASDAQ:WFMI) paid its first dividend in 2004 -- and, owing to industry headwinds, reported this month that it will be suspending its payments.

Despite speculation to the contrary, Bank of America (NYSE:BAC) has so far maintained its 30-year history of dividend increases. Whether it can continue to shield itself from industry headwinds remains to be seen.

High payout ratio
A company's payout ratio -- usually calculated as dividends divided by net income -- is one of the most commonly used metrics to determine whether it can afford to continue paying its dividend at the same rate. A high payout ratio suggests that a company is returning the vast majority of its earnings to shareholders and therefore may not have enough left over to fund future operations -- risking cut or suspended payments down the line.

Another good metric is free cash flow. Net income is an accounting construction that captures the gist of a company's operations, but it doesn't reflect how much cash a company actually has left over from its operations to cut your check.

Consider ruling out companies with a ratio above 80% or which are free cash flow negative.

Two companies risking a blowup
So, all that being said, which companies are likely to be the next dividend blowups?

According to the above criteria, these two might be next:

Data from Capital IQ.

Although both of these companies are yielding moderately high 4% to 6%, they're yields that their payout ratios suggest are unsustainable for lack of ready cash. And these companies are facing other problems as well.

Daimler is announcing job and production cuts in the face of reduced discretionary consumer spending and slumping demand for its fuel-inefficient SUV lineup.

Despite a recent jump in revenue, Host Hotels CEO reduced guidance to reflect leisure business declines, warning analysts that "it has become clear that the various pressure points of the overall economy are combining to depress lodging demand."

The silver lining ...
Dividend stocks have a history of putting money in investors' pockets, but choosing the right dividend stocks for a down market is critical to protecting your portfolio. Considering these warning signs of an unsustainable dividend will help you to achieve those golden returns dividends have to offer.

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Ilan Moscovitz owns shares in Whole Foods, a Motley Fool Stock Advisor recommendation. Bank of America is an Income Investor pick. The Motley Fool has a disclosure policy.