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 Lehman Brothers (NYSE:LEH) and National City (NYSE:NCC) know all too well.

Nearly 100 companies cut their dividends during the second quarter, the biggest quarterly decline since 1991. And fully 200 companies have now reduced their dividends in the past year. Their average performance during that time frame? Negative 44%.

To avoid the next dividend implosion, you have 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 CapitalSource (NYSE:CSE) announced on Monday that it would cut its quarterly dividend from $0.60 to $0.05, for example, the stock was "yielding" 18%.

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, and dividend cuts or suspensions often follow.

Demand remains strong for auto companies that specialize in emerging markets, such as Bombay-based Tata Motors (NYSE:TTM), but the outlook is more gloomy for companies doing business in the U.S. 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.-based automakers -- even hugely successful competitor Toyota (NYSE:TM) reported double-digit sales declines last quarter.

And it's only going to get worse. Ford 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 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 (NYSE:GE), the abiding example, has raised its dividend for 32 consecutive years and has paid a dividend every quarter since 1899. By contrast, Whole Foods paid its first dividend in 2004 -- and, as a result of industry headwinds, is now suspending its payments.

Of course, when history meets headwinds, sometimes the headwinds prevail. Despite more than 25 years of consecutive dividend increases under its belt, Fifth Third Bancorp proved unable to shield itself from the industry headwinds this time around.

High payout ratio
The payout ratio -- usually calculated as dividends divided by net income -- is one of the most commonly metrics companies use to determine whether they can afford to continue paying their dividends 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. Such a company risks having to cut or suspend 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 that 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:



FCF Payout Ratio


Allied Capital (NYSE:ALD)



Private Equity





Data from Capital IQ, a division of Standard & Poor's.

These companies are yielding a moderately high 5% to a very high 17%, and their payout ratios suggest that their yields are unsustainable, for lack of ready cash. These companies are facing other problems as well. Daimler, for example, is announcing job and production cuts in the face of reduced discretionary consumer spending and slumping demand for its fuel-inefficient SUV lineup.

Likewise, despite a recent jump in revenue, Host Hotels' CEO has reduced guidance and warned analysts 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 that dividends can offer.

If you'd like to see the dividend payers our team at Motley Fool Income Investor likes, including their 10 best bets for new money now, you can try the service free for 30 days. Click here for all the details -- there's no obligation to subscribe.

This article was first published Aug. 25, 2008. It has been updated.

Ilan Moscovitz owns shares in Whole Foods, a Motley Fool Stock Advisor recommendation. Tata Motors is a Global Gains selection. CapitalSource is an Income Investor pick and a Fool holding. The Motley Fool has a disclosure policy.