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 dividend payers 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 know all too well.

In 2009, S&P 500 companies skipped a record $52.6 billion in dividend payments. 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 show up when a stock has been beaten down -- which means investors don't have confidence in it.

Before Alcoa (NYSE: AA) reduced its quarterly dividend from $0.17 to $0.03 last year, the stock was "yielding" 11%. Its ability to afford to reinstate its previous payout will depend on aluminum demand and capital expenditures. However, based on analyst estimates, it seems reasonable to think the company could return to a $0.17 payout in a few years, if it so chooses.

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 such as energy may want to consider this: 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. Based on recent cash flow statements, Noble can easily afford its dividends. Spectra and Exxon seem safe. EOG .. not so much.

Spotty track record
Companies with 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, lowered capital expenditures and suspended its payments in August 2008. The company is weathering the economic storm quite well. With cash flow growing to an all-time high, could afford to reinstate its payouts should it decide to do so.

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.

The company has repaid its bailout money, and if analysts are right about profit expectations, the bank could afford to reinstate its former dividend within the next couple of years should it choose to.

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 dividends divided by 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 those with 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:



Net Income Payout Ratio

FCF Payout Ratio


NYSE Euronext (NYSE: NYX)




Financial Exchanges






Data from Capital IQ, a division of Standard & Poor's.
*Adjusted for one-time merger and exit costs.

NYSE Euronext continues to face increasing competition from Nasdaq OMX and shadow exchanges. Even if the company claws its way back, its dividend is simply too high.

GATX's rail fleet generates the bulk of the shipping company's revenue, but GATX is having trouble maintaining its pricing in a tough competitive environment. The company's CEO recently noted that markets still "aren't showing consistent signs of recovery."

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 that 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 Motley Fool Stock Advisor choice. Procter & Gamble and Spectra Energy are Motley Fool Income Investor picks. NYSE Euronext is a Rule Breakers selection. The Fool owns shares of Procter & Gamble. The Fool has a disclosure policy.