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 and Honda know all too well.
138 companies cut their dividends during the third quarter, the biggest quarterly decline since 1991, for a grand total of $22 billion in skipped payments. Fully 374 companies reduced their dividends in 2008. Their average performance during that time frame? Negative 57%.
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 Harley Davidson
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 geopolitical risk, monetary expansion, and declining supply, will lead to a sustained period of rising energy prices, or whether this economic downturn will continue to keep prices low.
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 Chesapeake
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.
Procter & Gamble, a diversified consumer staples maker largely shielded from economic cycles, has paid an uninterrupted dividend since 1890. By contrast, mining giant Freeport-McMoRan Copper & Gold
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 those 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:
|
Company |
Yield |
Levered FCF Payout Ratio |
Industry |
|---|---|---|---|
|
Calumet |
15.2% |
NA |
Refining |
|
General Electric |
10.8% |
NA |
Conglomerates |
Data from Capital IQ, a division of Standard & Poor's.
Their negative free cash flow suggests that their high yields are unsustainable for lack of ready cash. And they're facing other problems as well.
Calumet is running a free cash flow deficit and is burdened by $450 million debt. The company is concerned about its ability to service that debt, which until now it has been able to afford by issuing new shares and borrowing more money. But if oil prices remain low, their inventories will lose value, which would raise their cost of borrowing.
Since it opted for the more responsible route of writing its own subprime mortgages, GE loss rates remain lower than those of many of its peers. Still, to paraphrase the company's most recent filings and conference calls, this is a yucky environment in which to be holding mortgage-backed securities. So, while the company's infrastructure, technology, NBC, and consumer products divisions remain profitable, GE recently ratcheted up its credit loss estimates for 2009 to $10 billion.
JPMorgan recently called GE's AAA credit rating unsustainable, and Moody's has put the rating on review for possible downgrade, which, according to GE, could raise its cost of capital, thus weakening one of its major competitive advantages. Regarding the issue of whether GE's $12.4 billion dividend payout was safe, CEO Jeffrey Immelt summed up the situation best: "The board and I will continue to evaluate the company's dividend level for the second half of 2009 in light of the growing uncertainty in the economy, including U.S. government actions, rising unemployment and the recent announcements by the rating agencies."
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.
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This article was first published Aug. 25, 2008. It has been updated.
Ilan Moscovitz doesn't own shares of any companies mentioned in this article. Chesapeake Energy is a Motley Fool Inside Value pick. JPMorgan is an Income Investor recommendation. The Motley Fool owns shares of Procter & Gamble. The Motley Fool has a disclosure policy.
