If you've paid close attention to the markets here lately, it may seem like many companies -- as well as investors -- have caught "dividend fever." And for good reason.
With interest rates near record lows and companies sitting on record amounts of cash, it's been prime season for dividends. Times are good, and companies are feeling generous.
Companies have been hiking their payouts at a steady pace in recent years and show no sign of letting up. In fact, FactSet Research analyzed the broad spectrum of publicly traded U.S. stocks and found that companies paid out nearly $1.1 trillion in dividends in 2012. That's roughly 20% higher than a year earlier.
The prospects for 2013 are looking even better. According to a recent report by Standard & Poor's, companies are on track for a record year for dividend payments. Companies boosted dividend payments by 12% in the first quarter alone and 15.5% in the second quarter -- a trend that should continue well into the future.
But today, I'm here to tell you the picture is not always rosy.
As we all know, history repeats itself. Just five years ago, dozens of companies were forced to reduce -- or completely ditch -- their dividends as profits dried up and companies took a more defensive posture. So even as you scour the landscape for companies capable of solid dividend growth, you also need to steer clear of ones that are forced to buck the current trend and slash their payouts.
Here are four warning signs of a company with a vulnerable dividend:
1. An unsustainable payout ratio
Companies tend to dedicate 20% to 40% of their profits to their dividend. But when the payout ratio (dividend payments dividend by net income) rises above the 50% mark, you may want to investigate what's going on. Trouble often begins when profits begin to fall. It's a good exercise to look up the current payout ratio for all of your current holdings. If that figure has been rising fast toward 100%, the company may soon have to take the unpopular but necessary step of reducing or eliminating the dividend.
Keep in mind that some types of investment vehicles, such as master limited partnerships and real estate investment trusts are required to pay 90% or more of their profits to investors. So in these cases, a payout near 100% is neither uncommon nor undesirable.
2. Too much debt
In a move that reeks of recklessness, some companies may actually start to borrow money to support their rising dividend payments. Taking on debt increases the risk that a company will run into deep trouble if the economy slumps. The problems can be compounded if a portion of the debt is due in just the next year or two. Pretty soon, the company will be forced to choose between paying back its lenders and defending the dividend payments. And in this fight, the lenders will always win.
Take office machines supplier Pitney Bowes (NYSE: PBI) as an example. Earlier this year it was one of the top-yielding stocks in the S&P 500. But, the company was saddled with more debt than twice its cash levels. This mature company was unlikely to take on any more debt, and roughly 70% of its income was paid out to dividends in 2012. Not surprisingly, this company eventually had to chop its dividend in half in April.
3. Industry health
Defensive industries such as electric utilities or packaged food makers tend to generate steady financial results in any economic climate. As a result, they can pay steadily growing dividends year after year. But many companies toil in highly cyclical industries -- such as technology, construction, residential, or auto manufacturing -- that can go from bust to boom and back to bust in less than a decade. And when the inevitable cyclical downturn arrives, sales fall, cash flows dry up, and the dividend must be cut if the company's earnings can't keep up.
4. 'Too good too be true' yields
In most instances, if you see a stock sporting a dividend yield in excess of 10%, you should steer clear. Why's that? Because if a company was in a strong financial position and the investment community generally perceived future dividend payment streams to be safe, then they would rush to buy the stock. The resulting rising stock price would push the dividend yield lower. In effect, the market has natural forces that spot high-quality, high-yield stocks and then corrects the anomaly.
We already took note of Pitney Bowes' double-digit yield, and explained why the good times couldn't last, but other high-yielders are also lurking out there, waiting to lure in unwitting investors, only to punish them later.
A few examples may include NTELOS Holdings (Nasdaq: NTLS), Windstream Corp. (NYSE: WIN) and Prospect Capital (Nasdaq: PSEC), two of which have dividend yields in excess of 10%. These yields are too good to be true.
Trust me, I know it's not fun to think about what it would be like to spend part of your nest egg on an income stock -- only to see the dividend get cut and then have to deal with the ensuing panic.
That's exactly why I use these rules in every issue of High-Yield PRO, to seperate the quality high-yield stocks from the ones that belong on my "Dividend Blacklist" -- which shows readers the most troubled high-yielders on the market that should be avoided at all costs.
You owe it to yourself to examine your portfolio holdings for these warning signs before it's too late. But it would be even wiser to keep these points in mind before you ever buy a stock that pays a dividend.
P.S. -- These rules have helped my readers safely capture yields of up to 10.7% and gains as high as 245%. And starting right now, you can be on your way to similar results. I've just put together a brand-new report that will give you three of my favorite, safe, high-yield picks as a gift to help get you started on your very own High-Yield PRO portfolio today. To view this brief report, click here.
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