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 recent dividend-slashers know all too well.

Fully 374 companies reduced their dividends in 2008 for a grand total of $46 billion in skipped payments. 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 investors don't have confidence in it.

Before Harley-Davidson (NYSE:HOG) reduced its quarterly dividend from $0.33 to $0.10 last week, the stock was "yielding" 10%. 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, rising demand from emerging economies, and limited 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 (NYSE:CHK), Noble (NYSE:NE), Peabody Energy (NYSE:BTU), and Apache (NYSE:APA) -- 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, a diversified consumer staples maker largely shielded from economic cycles, has paid a dividend since it was first instituted in 1890. By contrast, mining giant Freeport-McMoRan Copper & Gold (NYSE:FCX) has only paid a steady dividend since 2003 -- and, as a result of industry headwinds, announced last year that it would suspend its payments.

Of course, when history meets headwinds, sometimes the headwinds prevail. Despite more than 70 years of maintaining or raising payouts, General Electric (NYSE:GE) 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 which 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:

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

Their yields are moderately high, while their free cash flow payout ratios suggest they may not be able to afford those payouts. And they're facing other problems as well.

Duke Energy's earnings are down 35% 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 Frontline's management insists that cutting its dividend from $3 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 is trying to conserve cash due to increasing expenditures, a weak 2009 environment, and the credit squeeze.

None of these factors looks 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 those golden returns dividends have to offer.

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

Ilan Moscovitz has no position in any company mentioned. Chesapeake Energy is an Inside Value recommendation. Procter & Gamble and Duke Energy are Income Investor selections. The Fool owns shares of Procter & Gamble and Chesapeake Energy. The Motley Fool has a disclosure policy.