These Dividends Are Done

It's scary out there for dividend investors.

Even with the recent rally, dividend yields are sky-high. According to Capital IQ, there are 1,222 stocks on our major exchanges that have yields of 5% or more. But a lot of these are dividend traps, enticing us with the promise of fat quarterly payouts only to cut them down the road.

As a stark reminder, we can look to General Electric. Once hailed as the safest of the safe, GE has in short succession gotten government help, cut its dividend to save cash and (hopefully) retain its AAA debt rating, and then lost that AAA status anyway.

And of course, big banks like Citigroup (NYSE:C) and Bank of America (NYSE:BAC) are another reminder of safe dividends gone scary.

The "5% of nothing" club
Traditionally, a 5% dividend yield has been eye-popping enough to elicit fears of a dividend cut. Now, it feels commonplace. When you see a blue chip like Kraft creeping up on a 5% yield, anything short of double digits starts to feel safe. And we start getting a little greedy.

But that greed can turn right back into fear if the great double-whammy curse of high-yielding stocks kicks in. After all, we buy dividend stocks because they provide a large, steady stream of income and have the promise of stock price appreciation. But then:

• In this environment, a susceptible high-yielding company's share price takes a beating. (Whammy!)
• In order to preserve precious capital, said company cuts or altogether eliminates its dividend, destroying dreams in the process. (Double-whammy!)

As a result, I view any dividend yield as a "too good to be true" situation until I've fully vetted the company. It's a good default stance on any stock you're considering buying. Let's take a quick look at some companies with plus-5% dividends to illustrate:

Source: Capital IQ, a division of Standard and Poor's.
*Not meaningful.

The story behind the numbers
The first thing I do when I see a tasty dividend is look for obvious problem areas. If I can spot a major problem quickly, it saves me further research.

Notice the payout ratios (the percentage of earnings a company pays out in dividends) in the table above. If I see a payout ratio greater than 50%, I get suspicious. I looked more closely at the bottom three companies.

Taiwan Semiconductor Manufacturing is basically paying out all its earnings as dividends. But that's not a huge red flag, because the company has had stable earnings and a huge net cash hoard.

While Reynolds American doesn't have a huge cash hoard, it only has a moderate amount of debt, which it covers easily with its steady cash flow from its tobacco operations. Note that its payout ratio is artificially high because of an impairment charge.

Of the list, the most likely candidate for future dividend slashes is commercial printer R.R. Donnelly & Sons. It's amassed a significant amount of debt and reported losses over the last couple years (hence a payout ratio that's not meaningful), stemming from what seem to be perennial restructuring charges. The company's had these charges every single year since 2001!

Which dividends will survive?
It's darn hard to determine the sustainability of dividends in this environment. Due diligence is important in any environment, but it's especially important now, when we can scoop up high-dividend plays that could form the core of our portfolios for decades to come.

The team at our Income Investor newsletter does their homework. They look for the most stable companies that pay the highest, most sustainable dividend yields. They've rated Kraft and its 4.4% yield a buy. But for new money, they rank seven sustainable dividend-paying stocks above Kraft. You can see all seven, and try out the entire service, for free with a 30-day trial. Click here to learn more -- there's no obligation to subscribe.

This article was originally published on May 7, 2009. It has been updated.

Anand Chokkavelu owns shares of Citigroup. In his spare time, he hosts a snack-food program called "These Doritos are Done." Kraft is an Income Investor recommendation. The Fool has a disclosure policy.