3 Deadly Dividend Stocks to Avoid

Dividend investing is all the rage. And what's not to love? Getting those four (typically) payments each year feels great for investors. It gives you a tangible affirmation that you're actually getting something out of owning those little pieces of paper sitting in your brokerage or retirement accounts. And beyond the positive affirmation those payments provide, research indicates that companies that pay dividends outperform the market. All in all, dividend investing seems likes an ironclad road to riches.

Unfortunately, not all dividends are created equal. And in that spirit, I want to highlight some indicators and examples of the wrong types of dividends.

Buyer beware
A high yielder can become deadly when its payout is so high, the company can't afford it anymore. When a company's payout ratio begins to rise about 75%, it's worth taking note. Such a high payout ratio means that the company in question pays more than three-quarters of its income out to owners. While this might sounds like an investor's dream (and not always a negative), such practices can also give companies very little breathing room in running their businesses, especially since evidence indicates firms will often go to destructive lengths to avoid cutting their dividends.

Keeping that in mind, let's look at three firms with dangerous dividends:

Source: Capital IQ, a division of Standard & Poor's.

Looking at these figures reminds of me of the famous Warren Buffett quote, "You don't know who's swimming naked until the tide goes out." While stocks paying out dividends in excess of 5% sounds amazing on paper, these eye-popping yields don't necessarily indicate safety. Each of these companies paid more out to their owners than they made last year.

While investors always love companies that pay consistent dividends, they generally prefer their firms avoid burning into their cash stores in order to keep the checks coming. Companies that find themselves in this situation usually have some kind of headwind affecting them and decide to maintain payouts in hopes that normal business conditions will eventually return. However, if those headwinds remain intact, such companies often need to reduce the size of their payouts. Such negative developments can sink investments.

The safer side of dividends
Contrast the stocks above with traditional stocks with histories of paying strong, consistent dividends:

Source: Capital IQ.

The discrepancies between these two tables demonstrate the difference between chasing yield and investing for income. The dividends in the first table appear to be on thin ice. The companies in the second table pay above-average yields while maintaining conservative payout ratios. Such old-school policies enable companies to keep those payments coming year after year. Keeping more normal payment schedules also enables these firms to invest spare cash back into their businesses, which can in turn lead to dividends that grow as time passes (another big plus for investors).

Trying to capture greater gains by taking on additional risk can hamper your performance over the long run. Investors only need to think back a few years to remember how "too good to be true" investments typically end. While we love high dividends, it's important to ensure that those payouts are also safe. Doing so could make the difference between a happy retirement and a few more years in the rat race.

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