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.

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 National City announced its first dividend cut last 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).

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 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 varied stalwarts such as Valero (NYSE:VLO), National-Oilwell Varco (NYSE:NOV), and Chesapeake Energy (NYSE:CHK) -- only one, ExxonMobil, 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.

Procter & Gamble (NYSE:PG), a diversified consumer staples maker largely shielded from economic cycles, has paid an uninterrupted dividend since 1890 and has raised it for 53 consecutive years. 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 last 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 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 with negative free cash flow.

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 Yahoo! Finance and Capital IQ, a division of Standard & Poor's.

Their yields range from moderately high (Frontline) to high (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. While major financial websites still show an enormous yield, the company is clear that it does not expect to pay any dividends at all this year.

While Frontline's management insists that cutting its dividend from $3.00 last September to $0.50 "does not in any way constitute a shift in Frontline's dividend strategy," it's hard to see it as anything but. Fast-forward several months and that dividend is now $0.25. The company's trying to conserve cash due to increasing expenditures, a weak 2009 environment, and the credit squeeze. None of these factors look likely to change, and analysts expect earnings to decline more than 80% this year. Given Frontline's high payout ratio and capital-intensive business, an actual strategic shift could make sense.

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 and National-Oilwell Varco are Income Investor recommendations. Chesapeake Energy is an Inside Value selection. Whole Foods and National-Oilwell Varco are Stock Advisor picks. The Fool owns shares of Procter & Gamble and has a disclosure policy.