3 Warning Signs for Dividend Investors

Fantastic dividends are often exactly that: too good to be true.

I learned that lesson the hard way four years ago. My retirement portfolio included a few shares of mortgage REIT NovaStar Financial because the stock paid a jaw-dropping 17% yield. To my untrained dividend-hunting eye, NovaStar's payouts looked solid enough because the real estate investment trust had been raising its common dividends year by year while also keeping its cash balances fairly stable. It was a guaranteed gold mine until my retiring days -- or so I thought.

Mirage, illusion, phantasm
But the giant dividend was standing on feet of clay. The juicy payout came from subprime mortgage sales, and by the summer of 2006, it was becoming obvious even to my inexpert self that NovaStar's good times were coming to an end. Too much debt tied up in repackaged mortgage bonds, not enough cash flow to keep the gravy train rolling, and the company was actually paying dividends out of the proceeds from printing fresh shares. Ouch.

Not long after that, NovaStar canceled its dividends and became an instant penny stock. I got lucky and backed out before the eternal rivers of dividend gold dried up. If not, I'd be left holding a worthless bag of reinvested dividends. The same thing could happen to any dividend darling today that can't back its fantastic payments up with a solid business.

Who's next?
The warning signs around NovaStar were plentiful:

• High dividend payments but low or negative cash flows. The money came from sources other than running the business.
• Massive short interest (particularly telling because of the high yields -- short-sellers lose money on those payouts).
• The company was under a heavy barrage of shareholder lawsuits, fraud claims, and executive changes. That much pressure on the corporate structure doesn't bode well for the future.

With these red flags in mind, let's take a look at some of the most generous divided stocks in 2010. If any of them reminds us of NovaStar, it might be time to take your dividends and run elsewhere.

Source: Capital IQ, a division of Standard & Poor's. TTM = trailing 12 months. Cash payout = TTM dividends divided by TTM operation cash flows.

Whys and wherefores
Some of these stocks pass the common-sense filters handed down by NovaStar and its ilk:

• PDL BioPharma runs a lucrative technology licensing business and pays a generous dividend out of massive cash flows, mostly thanks to a commitment to share the royalty spoils from a co-marketing agreement with Genentech (NYSE: DNA). This doesn't show up in a cursory scan of Yahoo! Finance, because PDL BioPharma classifies the Genentech distributions as special dividends rather than regular ones.

If there's a weak point in PDL BioPharma as a dividend play, it would be that the payouts have been known to drop from time to time rather than steadily increasing, but this is a fundamentally solid business -- at least for the next few years.

• I've gone on the record vouching for Frontier's dividends before, and there's nothing in the NovaStar warning signs that would sway me from that conclusion. Rural telecommunications is a low-growth industry, but monthly payments from millions of customers add up to form an impressive cash machine. It's an ideal breeding ground for reliable dividends.

Others don't necessarily pass the sniff test:

• Sycamore Networks isn't a regular dividend dynamo: The current astronomical yield is the result of a one-time cash distribution paid last December, a few days before a 1-for-10 reverse stock split. For all intents and purposes, the future yield on Sycamore is zero.
• Chimera's model is eerily similar to NovaStar's. It's another residential mortgage specialist that can't fund its dividends from cash flows alone, and the dilutive stock sales keep piling up. Danger, Will Robinson!
• American Capital Agency produces more operating cash than it pays out in dividends, but is also prone to dilutive stock sales. While possibly less risky than Chimera, the ghost of NovaStar haunts this company, too.

Take action, Fool!
None of the finds above are official recommendations, but should form a healthy base for further research. If you're still left searching for a dependable income stock after considering these factors, you may want to turn to less-flashy but time-tested payout performers. Obvious examples include Income Investor recommendation and trash-handling giant Waste Management (NYSE: WM) or maybe the dividend-flinging software champion of the Pacific Northwest.

And if you do smell signs of another NovaStar in your own portfolio, you have to make sure the comparisons are only superficial. Disappearing dividends are worse than not having one to begin with.