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 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.

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 National Oilwell Varco (NYSE: NOV), Williams Companies (NYSE: WMB), and Valero (NYSE: VLO) -- only one, ExxonMobil (NYSE: XOM), has managed to raise its dividend for 25 consecutive years.

Based on recent cash flow statements, National Oilwell and Exxon can easily afford their dividends; Williams and Valero aren't necessarily in the danger zone, but their payouts appear somewhat iffier.

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.

Of course, when history meets headwinds, sometimes the headwinds prevail. Despite more than 25 years of consecutive dividend increases under its belt, Wells Fargo proved unable to shield itself from the industry headwinds this time around.

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:

Data from Capital IQ, a division of Standard & Poor's.

Their yields range from moderately high (Textainer) to high (Vector), and their free cash flow payout ratios suggest trouble may be brewing.

While the tobacco industry is known for its reliability, Vector Group, the maker of Liggett cigarettes, pays out significantly more cash than it generates.

Textainer, the freight container leasing company, has been free cash flow-negative every year since 2006.

The silver lining...
It might be tempting to conclude from these numbers that we've found two stocks worth shorting. But it can be painful to short dividend stocks, since you, as the short seller, are responsible for paying those dividends.

In other words, an unsustainable dividend policy is one thing, but when shorting stocks, you want to look for other red flags as well: operational difficulties, weak competitive positions, and dangerous accounting shenanigans.

If you'd like to learn more about ways to spot potential ticking time bombs, whether to protect your portfolio or profit on short ideas, enter your email in the box below to receive CFA John Del Vecchio's free report "5 Red Flags -- How to Find the Big Short." Del Vecchio has an impeccable record as an analyst and a money manager; most recently, he managed the Ranger Short Only portfolio from 2007 to 2010, where he outperformed the S&P 500 by 40 percentage points. John's report is free, and it's the first step toward putting powerful analytical tools to work for your portfolio.