Warning: High Dividends Are Dangerous!

A few days ago, I wrote an article about retirees needing to invest in dividend stocks in order to offset the eventual decline in bond returns over the next decade or so. I received an excellent comment from a Motley Fool reader that made me want to elaborate on the subject and provide further guidance.

What can go wrong?
Dividend stocks have outperformed their non-dividend-paying peers for decades. There’s absolutely no denying the power of reinvesting your dividends and being paid quarterly or annually to hold the stock you own. Dividend stocks, simply put, are value-creating machines.

However, that’s not to say that you can approach them without caution. Dividends, just like anything else, can come and go at the whim of higher management. In 2008, during the financial crisis, handfuls of respectable companies like General Electric and Dow Chemical were forced to suspend or cut their dividend. More recently, shareholders of BP have felt the pain of a dividend suspension as the company attempts to deal with the Deepwater Horizon oil spill debacle.

Looking for high yields with caution
So what do you do to ensure your dividends are safe?

I have two suggestions that can help you feel more comfortable about the dividends you’re currently receiving. First, take a look at the company’s payout ratio; this metric tells you what percentage of a company’s net income is being paid out in cash. A high payout ratio (anything more than 60% deserves a red flag, in my book) means that a company may have issues continuing its dividend in the future and warrants additional attention. Second, look at the company’s history. Has it been paying dividends for quite some time? Has it consistently been increasing those dividends? If you can answer “yes” to both, chances are that your dividends are relatively safe.

For instance, CenturyLink (NYSE: CTL) is a domestic telecom provider that has been around for more than 40 years. It pays an excellent 8% dividend, but more importantly, it’s been paying that cash to shareholders since 1974 and has increased it 36 years in a row! Not to say that things can’t change, but you should feel comfortable knowing CenturyLink’s history.

The comment I received last week was from Motley Fool reader TxSailor, who questioned my recommendation of another domestic telecom provider, Windstream (NYSE: WIN). This was the comment:

You have me scratching my head regarding your suggestion of WIN as a way to gain wealth. I checked and their payout is 137% and their debt of $6.34 billion is serviced by a free cash flow of $0.67 billion which would suggest a 10 year ratio. Their income growth is a minus 16%. With 4 million shares at $1.00 per share, I would guess they are borrowing to pay dividends. I know I am missing something. Perhaps you could guide me in your reasoning for selecting this company.

This was an excellent observation and a great comment. What I explained to TxSailor was that although the earnings-based payout ratio is very high, the company has more than enough free cash flow to cover the payments. Despite its seemingly high long-term debt, most of that debt doesn’t come due until five years out. Nevertheless, this is certainly something to keep a close eye on going forward if you are an investor in Windstream and count on that 8.7% dividend as a form of income.

Here are five great stocks
In order to provide another dividend-oriented article that will hopefully help our readers find stocks that can provide both growth and income, I decided to revisit my last article and update it.

This time, I ran a screen for stocks that pay dividends above 3%, have payout ratios below 60%, and trade at P/E multiples below 15 (in order to ensure good value). Below, I’ve chosen what I think are five of the most promising stocks from that screen.

Source: Capital IQ, a division of Standard & Poor’s. P/E ratios are before extraordinary items.

Each of these companies pays a great dividend, is trading reasonably, and has a payout ratio that doesn’t raise any immediate warning flags.

Let’s look at ConocoPhillips as a solid example. Not only does it have the attributes mentioned above, but it’s been paying dividends since 1934 and has been able to raise them consecutively for the past nine years. Neither the swings in the commodity cycle nor the financial panic of 2008 were enough to shake the foundation of this company’s obligation to its shareholders, and that’s a terrific thing to see.

The bottom line is that dividend stocks should be an integral part of every investor’s portfolio. They provide steady income and present the opportunity for unlimited growth potential as well. But with all investments, you must proceed with due diligence and make certain that you’re making sound choices based on all available information. Hopefully these companies can pique your interest or at least help you find the most popular dividend stock around!

Have a great dividend suggestion? Sound off in the comments section below!