Are These Dividends Too Good to Be True?

With investors increasingly beginning to believe that the stock market's long rally will come to an end soon, many are looking to position their portfolios for what they see as an inevitable correction. Yet although dividend-paying stocks can give you an ideal combination of current income, conservative growth, and protection from huge drops in the overall stock market, the wrong dividend stocks can bring you a lot of heartbreak.

Lots of high yields
If you look around right now, you'll find plenty of stocks sporting extremely attractive yields. For instance, take a look at these stocks, all of which are in the S&P 500 and all of which have dividend yields of 5% or more:

Source: Yahoo! Finance. As of Nov. 20.

At first glance, you'll notice that these stocks encompass a number of different sectors throughout the economy. From tobacco and telecom to utilities and real estate, you could put together a fairly well-diversified portfolio simply by focusing on stocks that pay rich dividends.

So should you just go in and buy these top-yielding stocks right now? The answer isn't as simple as you might think.

A brief look back
The problem with focusing on high-yield dividend stocks is that almost by definition, they're typically in a state of flux, and you can't count on them to be dependable. Think about it: If investors were confident about the ability of a company to continue paying a high dividend, then they would probably bid up the company's shares, thereby lowering the yield as the share price increased.

In contrast, it often turns out that skeptical investors are correct that a particular company can't sustain a high dividend payout over the long run. In that case, once the company cuts its dividend, you'll often see the yield fall to a much more reasonable level that's in line with what most other companies pay.

In the past year, you've seen companies in both of these categories. For instance, prior to its first dividend cut in early 2008, Citigroup (NYSE:C) had a yield of 5.2%. Yet in the ensuing two years, the dividend has been eliminated, and shares have fallen almost 90% despite their big rebound since March. Similarly, in February, Pfizer (NYSE:PFE) had a dividend yield over 10%, but after the company cut its dividend in half, the shares now have a healthy but more realistic yield of 3.5%.

On the other hand, healthy companies have seen their shares bid up in a big way. For instance, Coca-Cola (NYSE:KO) had a yield over 4% in March. Now, though, its shares yield less than 3%, not because of any dividend cut -- the payout is actually higher now than it was then -- but rather because its shares are up significantly. Similarly, Merck (NYSE:MRK) has seen its yield fall from over 7.5% in March to a more modest 4.2% today.

What the future holds
How, then, can you tell whether your dividend stock will be a winner or a loser? Look out for two key things:

• History. Seeing where your stock's dividend has been in the past can be a vital clue in deciding where it's likely to go in the coming months and years. A strong history of steadily rising dividends is a good sign that a company might sustain a healthy dividend, whereas a spotty dividend history combined with a recent drop in share price strongly suggests that something bad could happen soon.
• Earnings. It's critical for a high-yielding dividend stock to have the earnings to back up its payouts. Without them, a dividend may not be sustainable; and even if the company does find a way to keep making payments, the fundamentals underlying those dividends aren't as good.

Before you run out and buy a high-yielding dividend stock, be sure to take a close look to see if it's realistic or not. What you discover could stop you from making what could be one of the worst investing mistakes of your life.

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