You may have heard that dividend stocks have historically significantly outperformed their stingier counterparts. 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 from Citigroup to Weyerhaeuser 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 price 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.

Whatever the long-term trends for energy may be, the recent plunge in crude prices is a stark reminder of that sector's cyclicality.

Investors looking to collect steady 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 stalwarts as Chevron (NYSE:CVX), ConocoPhillips (NYSE:COP), and Schlumberger (NYSE:SLB) -- only one, ExxonMobil (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.

Johnson & Johnson (NYSE:JNJ), a diversified producer of medical supplies, has paid a dividend since 1972. 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 (NYSE:FITB) proved unable to shield itself from the industry headwinds this time around and had to cut its dividend earlier this 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. Therefore, it may not have enough left over to fund future operations or battle downturns, 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


Duke Energy (NYSE:DUK)


NA (negative FCF)


Boston Properties



Real Estate

Data from Capital IQ, a division of Standard & Poor's. NA = not available.

Their yields range from moderately high (Boston Properties) to high (Duke), and their free-cash-flow payout ratios suggest they may not be able to afford those payouts -- especially Duke, which hasn't even had positive free cash flow for some time. And they're facing other problems as well.

Duke Energy's earnings are down 30% over the past 12 months, largely due to lower demand for electricity from its industrial customers that have been hit by the recession. The company is committed to spending billions on new coal and wind projects that it says will generate high returns, though with over $13 billion in net debt and more than $1.6 billion free cash flow shortfall, lightening up on its hefty payouts may be an option for the time being.

While inquiries into Boston Properties' Manhattan locations have picked up from what their president described as a "standstill" rate, high unemployment continues to plague commercial leasing. With that in mind, in its most recent conference call, the company (prudently) announced that it will likely need to reduce its dividend.

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 payout will help you to achieve the golden returns that dividends have to 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.

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Ilan Moscovitz owns share of Whole Foods, a Motley Fool Stock Advisor recommendation. Johnson & Johnson and Duke Energy are Income Investor selections. The Motley Fool has a disclosure policy.