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 First Horizon (NYSE:FHN) and UBS know all too well.

Nearly 100 companies cut their dividends during the second quarter, the biggest quarterly decline since 1991. And fully 285 companies have now reduced their dividends in the past year alone. Their average performance during that time frame? Negative 56%.

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 that investors don't have confidence in it.

When National City announced its first dividend cut in January, for example, the stock was "yielding" 10%. Since then, the stock has fallen more than 80%, and the company agreed to be acquired by PNC (NYSE:PNC).

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.

One of the major unknowns right now is whether major inflationary factors, such as increasing geopolitical risk, rising demand, and limited supply, will lead to a sustained period of rising energy prices, or whether this economic downturn will drive prices down.

While I don’t believe we will see cheap oil anytime soon, when it comes to dividends, oil’s historical cyclicality can’t be easily written off.

Investors looking to collect dividends over the next several decades from cyclical industries like energy may want to consider that of all the S&P 500 members of the energy sector -- a group that includes such varied stalwarts as Valero (NYSE:VLO), National-Oilwell Varco, and Chesapeake Energy (NYSE:CHK) -- only one, Exxon Mobil (NYSE:XOM), has managed to raise its dividend for 25 consecutive years.

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.

PepsiCo (NYSE:PEP), a snack and beverage-maker largely shielded from economic cycles, has been raising its dividend for over three decades. By contrast, luxury grocer 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 and had to cut its dividend earlier in the year.

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 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:

Data from Capital IQ.

Both of these companies are yielding 8% to 16%, which their payout ratios suggest are unsustainable for lack of ready cash. And these companies are facing other problems as well.

Last week, Blackstone announced another $509 million in quarterly losses stemming from the market meltdown that George Soros predicts could wring out as many as two-thirds of all hedge funds. In a statement, the company acknowledged that their fourth quarter dividend payment might come out "significantly lower," but that next years' payout "looks pretty secure." Yet, Blackstone’s CEO remarked during the conference call that "no one can predict how deep or long [the recession] will be," so the company may not have much choice in the matter.

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 that dividends have to offer.

If you'd like to see the dividend payers that 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. Chesapeake Energy is an Inside Value pick. The Motley Fool has a disclosure policy.