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 or mortgage REIT NovaStar Financial because the stock paid a jaw-dropping 17% dividend yield. To my untrained dividend-hunting eye, NovaStar's payouts looked solid enough as the company had been raising its common dividends year by year while also keeping its cash balances fairly stable. It was a guaranteed goldmine 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 remind us of NovaStar, it might be time to take your dividends are run elsewhere.

Company TTM Dividend Yield (%) Cash Payout Ratio (%) Short Interest (%) CAPS Rating (out of 5)
National Beverage Company (Nasdaq: FIZZ)




Partner Communications (Nasdaq: PTNR)




Teekay Tankers (NYSE: TNK)




Encore Energy Partners (NYSE: ENP)




Consolidated Communications Holdings (Nasdaq: CNSL)





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

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

  • Consolidated Communications is about as squeaky-clean a business as you'll find among high-dividend payers. The company buys back more stock than it sells, easily covers dividend costs out of free cash flows, and hasn't taken on new debt since 2007 -- and even then, Consolidated was financing a $347 million buyout of a regional telecom. No signs of a new NovaStar here.
  • Partner Communications buys back a lot of stock, which is good. However, the Israeli telecom raised fresh debt in recent years faster than it could pay the old loans back, and doesn't have the excuse of large acquisitions for that ugly habit. For now, cash flows look strong enough to support the dividend, and the borrowing habit hasn't caused terrible damage. Our Income Investor team doesn't seem too worried about Partner's debt, but it's a bit of a red flag from my NovaStar experience.

Others don't necessarily pass the sniff test:

  • At first blush, National Beverage's dividend looks way too big. The reason for this is that the company doesn't pay a steady, annual or quarterly dividend like a true dividend dynamo would. Instead, it pays out a tremendous special dividend once in a blue moon accompanied by really colorful press releases. This is probably not the stock you want as a true-blue income investor -- though the company doesn't look ready to implode, either.
  • Teekay Tankers is a different animal altogether. It's an oil tanker operator like Frontline (NYSE: FRO), only dead-set on returning cash to shareholders rather than investing in business growth. I'm not convinced that the cash machine here is strong enough to support these payouts, and heavily dilutive stock sales seem to support my misgivings.
  • Then there's oil and gas exploration company Encore Energy, whose large dividends made its first appearance in 2008 -- which is also when the company's debt load started to creep up. Also, the company often has large capital expenses that sap the cash-making prowess of its operations, making the generous dividend unrealistic in the long run.

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 longtime Income Investor recommendation and liquor legend Diageo (NYSE: DEO).

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.