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 Teck Cominco (NYSE:TCK) and Weyerhaeuser (NYSE:WY) know all too well.

During the third quarter, 138 companies cut their dividends, 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 Wachovia announced last July 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.

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, December sales fell 36% to their lowest level in 16 years. The hurt isn't restricted to U.S.-based automakers -- even hugely successful competitor Toyota (NYSE:TM) had to cut its dividend for the first time in more than a decade.

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 that is largely shielded from economic cycles, has paid an uninterrupted dividend since 1890. By contrast, Whole Foods paid its first dividend in 2004 -- and, owing to industry headwinds, suspended its payments in August 2008.

Of course, when history meets headwinds, sometimes the headwinds prevail. Despite more than 25 years of consecutive dividend increases under its belt, Wells Fargo (NYSE:WFC) proved unable to shield itself from the industry headwinds this time around.

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. Therefore, it 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:



FCF Payout Ratio


Allied Capital (NYSE:ALD)



Private Equity

Caterpillar (NYSE:CAT)



Construction Machinery

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

Their yields range from moderately high (Caterpillar) to absurd (Allied Capital), and their free cash flow payout ratios suggest they may not be able to afford those payouts. And they're facing other problems as well.

Allied Capital relies on the debt markets and share issuances for financing -- but with credit markets shaky, uncertainty about the company's ability to negotiate relief from its lenders, and shares down some 90% over the past year, both of those options look dubious. With such a high yield and payout ratio, investors are betting that when push comes to shove, the dividend gets knocked down, and management has commented that it’s likely the dividend will need to be dropped.

Caterpillar announced an additional 20,000 layoffs in January in order to "dramatically reduc[e] production schedules and costs in light of poor economic conditions throughout the world," according to CEO Jim Owens. The company expects earnings to decline by more than 50% this year. While Caterpillar is maintaining its dividend for the time being, a heavy debt load means that a dividend cut may be in the cards should the economy and commodities remain depressed.

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 the golden returns that dividends have to offer.

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

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Ilan Moscovitz owns share of Whole Foods, a Motley Fool Stock Advisor recommendation. Procter & Gamble is an Income Investor selection and Fool holding. The Motley Fool has a disclosure policy.