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.

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 Citigroup and Weyerhaeuser 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 Chevron (NYSE:CVX), ConocoPhillips (NYSE:COP), and Schlumberger (NYSE:SLB) -- only one, ExxonMobil (NYSE:XOM), has managed to raise its dividend for more than 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.

Johnson & Johnson (NYSE:JNJ), a diversified producer of medical supplies, has raised its dividend for 47 consecutive years. By contrast, luxury grocer Whole Foods paid its first dividend in 2004 -- and, as a result of industry headwinds, had to suspend its payments last year.

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 (NYSE:FITB) proved unable to shield itself from the industry headwinds this time around and had to cut its dividend earlier this 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 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:

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

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

Last quarter, Lan's sales fell 19%; fewer people are flying, and fewer companies shipping cargo. While there are some signs traffic may be picking up, fuel prices are rising as well, and the company doesn't generate nearly enough free cash flow to pay even the lower yield that some financial websites display. (Its dividends are dependent on earnings, and as such, the calculated yield isn't consistent.)

While GATX's rail fleet remains booked, lease rates are declining, and marine rates remain depressed. The company's CEO noted that "markets remain extremely challenging and competitive," and that pricing pressure will remain in force at least through 2010.

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.

If you'd like to see the dividend payers our team at Motley Fool Income Investor likes, including their 10 best bets for new money now, you can try the service free for 30 days. Click here for all the details -- there's no obligation to subscribe.

Already a member of Income Investor? Log in at the top of this page.

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

Ilan Moscovitz owns shares of Whole Foods, a Motley Fool Stock Advisor recommendation. Johnson & Johnson is an Income Investor selection. The Motley Fool has a disclosure policy.