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.

That'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 Teck Resources (NYSE:TCK) and Weyerhaeuser (NYSE:WY) know all too well.

Fully 374 companies reduced their dividends in 2008, for a record $46 billion in skipped payments. Their average performance during that time frame? Negative 57%. And this year, we've already broken the record set in 2008.

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.

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.

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 Spectra Energy (NYSE:SE), Noble Energy (NYSE:NBL), and EOG (NYSE:EOG) -- 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 that is largely shielded from economic cycles, has paid an uninterrupted dividend since 1890. By contrast, Whole Foods paid its first dividend in 2004 -- and, owing to industry headwinds, suspended its payments in August 2008.

Of course, when history meets headwinds, sometimes the headwinds prevail. Despite more than 25 years of consecutive dividend increases under its belt, Wells Fargo (NYSE:WFC) proved unable to shield itself from the industry headwinds this time around.

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 greater than 80%, or negative free cash flow.

Two companies risking a blowup
So which companies will likely be the next dividend blowups? According to the above criteria, possibly these two:



FCF Payout Ratio


Ares Capital (NASDAQ:ARCC)



Specialty Finance

CPFL Energia

7.5 %


Electric Utilities

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 challenges as well.

On Monday, Ares Capital announced it would buy troubled Allied Capital in an all-stock deal worth $648 million. The combined company will get Allied's significant assets, but also the cumbersome debt load that contributed to Allied's losses and dividend suspension -- and now Moody's is considering upgrading Allied, but downgrading Ares.

This may or may not be a good deal for Ares shareholders, but the company may need to scale back its payouts to combat a more precarious financial position, at least for the time being.

CPFL has a stated policy of paying at least 50% of its net income in the form of dividends, but it tends to pay around twice that amount. Add in huge capital expenditures, and you have a company that is paying out way more cash in dividends than it takes in.

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 owns shares of Whole Foods, a Stock Advisor recommendation. Procter & Gamble and Spectra Energy are Income Investor selections. Moody’s is a Stock Advisor pick. The Fool owns shares of Procter & Gamble. The Motley Fool has a disclosure policy.