These Dividends Are Done

Editor's note: This article originally listed Southern Copper with a dividend yield of 5.8%. We regret the error.

It's been a scary year for dividend investors.

Even with the recent rally, dividend yields are sky-high. According to Capital IQ, there are 1,113 stocks on our major exchanges with yields of 5% or more. But many 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 received government help, cut its dividend to save cash and (hopefully) retain its AAA debt rating, and then lost that AAA status anyway.

More examples abound, from Harley-Davidson (NYSE:HOG) to Nokia (NYSE:NOK) to PNC (NYSE:PNC) and the rest of the big banks.

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!)
• 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 5%-plus dividends:

Source: Capital IQ (a division of Standard and Poor's).

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. When the payout ratio goes above 100%, that means dividends aren't currently being covered by earnings.

Worse than a payout ratio greater than 100% is one that is negative -- that is, the company is paying out dividends despite reporting a loss.

So while I would certainly look closely at the quality of earnings of the four companies with payout ratios above 50% (or any company for that matter) before investing in their stocks, I would be even more skeptical of the dividend sustainability of Horizon Lines, which has a negative payout ratio.

Now, keep in mind that the payout ratio is just one metric. It's certainly useful for screening purposes, but further research fills in the picture. For instance, those making the bull case for Horizon Lines would point to the company's positive free cash flow as evidence of dividend sustainability.

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 folks at our Motley Fool Income Investor newsletter do their homework. They look for the most stable companies that pay the highest, most sustainable dividend yields. They actually recently took Kraft off their list of recommendations, not because it's a bad company, but because they see better opportunities out there.

For new money, they rank six sustainable dividend-paying stocks as "buy first" candidates. You can see all six, and try out the entire service, for free with a 30-day trial. Click here to learn more -- there's no obligation to subscribe.

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

Anand Chokkavelu owns shares in Harley-Davidson. In his spare time, he hosts a snack-food program called These Doritos Are Done. Nokia is a Motley Fool Inside Value recommendation. Philippine Long Distance Telephone is an Income Investor pick. The Fool has a disclosure policy.