5 Keys to Successful Dividend Investing

In 2008 and 2009, the dividend landscape was turned upside-down. During the fourth quarter of 2008 alone, 288 companies cut payouts. Not to be outdone, according to Standard & Poor's, another 804 dividend payments were cut by public companies in 2009 -- costing investors another $58 billion.

Nevertheless, amid all the dividend cuts and suspensions of the past two years, we were reminded of five key lessons that we can use to our advantage going forward.

Lesson 1: Stock dividends are a privilege, not a right
The first and most obvious lesson -- that dividends are not guaranteed -- was also a truism most people ignored in the years leading up to the dividend crisis. But unlike interest from bonds and CDs, a company's board of directors must choose whether or not to pay out cash dividends to shareholders.

There are obvious incentives for a board to maintain or increase regular dividend payouts -- it helps attract income-minded investors and is a sign of financial strength -- but in times of severe uncertainty, particularly in a credit-driven panic like we had, cutting the dividend to raise or preserve cash becomes a more attractive option for companies. This is exactly what Pfizer (NYSE: PFE  ) did last January, when it cut its dividend in half to fund its acquisition of Wyeth.

When one company cuts its dividend, it usually signals an inability to manage its finances. That cut becomes a scarlet letter for the firm. As we saw over the past two years, however, if many companies are in the same boat, the stigma of a cut is lessened, making it a more attractive option for cash-strapped boards.

Lesson 2: Beware of chasing high yields
Over the past decade, with interest rates and market yields relatively low, income-thirsty investors were forced to go further up the risk ladder to find agreeable yields -- and many have paid the price.

During the last bull market, for example, people piled into real-estate investment trusts (REITs), which were paying out handsomely on the back of the real estate boom. When properties stopped generating as much money, through broken contracts, unleased space, or lessees behind on their rent, the dividends took the hit. A number of REITs, like apartment-owner Equity Residential and shopping mall operator Simon Property Group, had to cut their payouts last year.

A good rule of thumb is to be skeptical of any dividend yield more than two-and-a-half times the broader market average (currently 2%, so be wary of 5%-plus). Anything over that amount implies that either the market has concerns about the company's ability to grow, or the stock price has fallen sharply for good reason.

In June 2008, for instance, Bank of America (NYSE: BAC  ) had a yield greater than 10%, at a time when the market average was around 2%-3% -- a good indication that the dividend was anything but assured. Sadly, it was not.

Lesson 3: Focus on cash, not earnings
While earnings are an accountant's opinion, cash is fact. Without enough actual cash to pay the dividend, the company must fund it with either debt or by selling stock -- neither of which is sustainable.

To determine whether or not a dividend is sustainable, first look at cash flow from operations going back five years or more. Then subtract capital expenditures from each of those years. Whatever is left over can be considered "free cash flow," which the company can use to pay dividends or repurchase shares.

Next, look further down the cash flow statement and see how much the firm paid in cash dividends each year. If that figure is consistently less than free cash flow, it's a good sign that the firm has enough cash to maintain its current dividend. Three names that fit this bill today are:

Company

Dividend Yield

Free Cash Flow Payout Ratio

Procter & Gamble (NYSE: PG  )

2.9%

40%

McDonalds (NYSE: MCD  )

3.5%

58%

Lockheed Martin

3.3%

23%

*Data provided by Capital IQ, as of Jan. 25, 2010.

Lesson 4: Diversification still matters
While many sectors experienced dividend cuts over the past two years, none were hurt as much as the financial sector, which at one point made up 30% of all dividend income from S&P 500 members. That's now down to 9%, according to S&P analyst Howard Silverblatt. But despite the gloom in financials, 33 of the 34 dividend actions taken by consumer staples stocks in the S&P 500 last year were positive.

A dividend-focused portfolio that was diversified across sectors still likely took a hit during the financial crisis, but less so than one heavily exposed to financial stocks for their higher yields. That's why sector diversification matters, even if you need to sacrifice a little yield in the near-term.

Lesson 5: Selectivity is paramount
Because dividend cuts can be wide-ranging during a financial crisis, your best bet is to hand-select a diversified group of strong dividend payers, rather than assuming that dividend-themed indexes and ETFs will save you.

For example, in December 2008, the dividend-weighted WisdomTree Equity Income ETF was heavily invested in General Electric (NYSE: GE  ) , US Bancorp (NYSE: USB  ) , and Wells Fargo (NYSE: WFC  ) , all of which slashed their payouts in coming months.

To make matters worse, since the ETF is only allowed to rebalance once per year, owners of the ETF were forced to hold many stocks that either stopped paying dividends or drastically reduced their payouts until the ETF was allowed to rebalance.

Wrapping it up
The five keys to successful dividend investing will help you build a diversified portfolio of hand-selected dividend payers with above-average but modest yields, well-covered by plenty of free cash flow. Pair this group with high-quality investment-grade bonds and a smattering of REITs, and you'll have built yourself a well-rounded income-focused portfolio that can help you achieve solid profits without undue risk.

If you'd like help getting started with this strategy, our Motley Fool Income Investor service can help. Advisor James Early and his team have assembled a group of stocks with an average yield of 4.1% and provide valuations and risk ratings for each recommendation. You can start your free, 30-day trial to Income Investor by clicking here.

Fool analyst Todd Wenning recommends Salt: A World History by Mark Kurlansky for fellow history geeks. He owns shares of Procter & Gamble, an Income Investor recommendation. Pfizer is a Motley Fool Inside Value selection. The Fool owns shares of Procter & Gamble and has a disclosure policy.


Read/Post Comments (20) | Recommend This Article (177)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 25, 2010, at 4:55 PM, goalie37 wrote:

    Very nice article, although I would argue that cash flow and diversification are truisms that apply to all stocks, not just dividend payers. I would also suggest the importance of the payout ratio, which is vital when a corporation's earning dry up, even if temporary.

  • Report this Comment On January 25, 2010, at 5:28 PM, drchang wrote:

    What about ETP and KMP ? Both have a good track record.

  • Report this Comment On January 25, 2010, at 5:35 PM, stockminer5 wrote:

    I agree with goalie37, keep an eye on the payout ratio.

    Top 250 list of the highest dividend yielding stocks:

    http://www.TopYields.nl/Top-250-dividend-yields.php

  • Report this Comment On January 25, 2010, at 6:13 PM, ndallasj wrote:

    The chart should be the ratio of payouts to free cash flow, not the other way around as shown. (I don't think Lockheed is paying a dividned that is more than 4 times their FCF!!!)

  • Report this Comment On January 25, 2010, at 6:39 PM, PeyDaFool wrote:

    Great article, Todd. I found it very interesting.

  • Report this Comment On January 26, 2010, at 6:34 AM, jaketen2001 wrote:

    What a good article. I would love for TMF to do a piece on MLPs, natural gas MLP in particular, and determine whether or not they thought the 'dividends' are sustainable. They have run pieces before discussing them, but not so much about the sustainability of the participation. some of these, as recent as a month ago, were huge, around 15% in some cases. The sector has rallied but the participation is still at 8-9% in some cases. Please Todd. Ha.

    Thanks

  • Report this Comment On January 26, 2010, at 6:48 AM, jaketen2001 wrote:

    to add on--

    yes stay away from dividend ETFs are bad--but are there dividend funds out there? And how have they done? And what about muni funds and corporate funds...the spectrum of dividend choices out there. Again, please.

    Thanks

  • Report this Comment On January 26, 2010, at 12:16 PM, halbiz wrote:

    How do you feel about the Dogs of the Dow investing, or the Small Dogs of the Dow, investing once a year (anytime during the year in my case) and then looking at it again the same time next year.......buying when dividend ratio is highest (stock lowest) and selling when the stock is no longer in the top 5 of dividend percent (ie, the stock has gone up), and replacing with the stocks that now fit the highest dividend % of the DOW.

    This gives a buy and a sell strategy and does not require daily in and out short term investing and trying to time the market...?

  • Report this Comment On January 27, 2010, at 7:21 PM, stan8331 wrote:

    Good article. I would argue that the rate being paid is less important than both the payout ratio and rate of dividend growth, especially for long-term investors. There are some very solid companies paying high dividends, even into double digits, along with many more problematic ones. Many of the most lucrative long-term dividend plays come from high-growth companies currently paying small dividends. And of course there are some classes of companies whose business model is based around a high payout ratio. I like to diversify across not only different market sectors, but also across these different sorts of dividend-paying companies.

    Hope to see even more dividend coverage on the Fool - dividends can be a great multiplier, even for those following a growth-oriented investment strategy, and they're especially important for retirement investing.

  • Report this Comment On January 29, 2010, at 3:38 PM, mikecart1 wrote:

    Where is MO, T, VZ? All better dividends than the ones in this article. JESUS!

  • Report this Comment On January 29, 2010, at 6:32 PM, silverfox67 wrote:

    Good article Todd..

    I've been investing in dividend stocks since August 2009. I use a similar screen to Todd's.

    div. 2-6%, P/E <15, P/CF <10; Analyst rating <3; I also look to companies that are still 20-30% off their 3 year high. I won't buy financial stocks.

    Since I'm in a tax deferred IRA, I sell with 10% gain.

    I've done great with: VZ, T, BMY, DEO, XEL, BMY, AEP, KMP. If I had held on to any of these after 10% I would be down with the 2010 -7% adjustment.

    My only dog has been EXC- any comments why EXC is underperforming?

    This seems like good plan for senior investors during "bouncing bull" market. I know you can't time the market, but that was before hedge funds!

    regards.

  • Report this Comment On February 01, 2010, at 10:31 AM, silverfox67 wrote:

    Todd:

    I select consistent dividend companies as indicator of well managed companies with good cash flow. If I hung on to above companies by Jan. 31, they were collectively down by 5%.

    I replaced them with similar stocks (HD, PG, GIS,YUM) and will sell at 10%. I ususally get one quarters dividends before selling.

    My concern is big investors love the stock volatility and are causing the swings. When I see more stability in the market, I will pick the best ones and hold long term as you suggest.

    regards and thanks!

    Good hobby for senior part time quality consultant.

    Milt

  • Report this Comment On December 13, 2010, at 12:43 PM, zbouck wrote:

    Dividend ETF's are not optimal, but they are good for diversification for someone who doesn't have the capital to buy 10 different dividend stocks.

  • Report this Comment On February 23, 2011, at 7:32 PM, moneybunny100 wrote:

    I am sold on dividend investing and I really appreciated the article by Todd. I wonder if you could give me and all other fools a list of Monthly Dividend Paying stocks. I understand a list can be had, but you have to drop some leaves in order to get it. Thanks. Fool on!

  • Report this Comment On December 17, 2011, at 8:57 PM, busterbuddy wrote:

    Good Article and some well defined issues. However, today you can buy $GE with a 4% yield. And REITs like $O that provide monthly dividend payments.

    Beware advice however. Several years ago while chatting on MF about utilities, a gentlemen recommended a good utility I'd not heard of with good yield. You could also DRIP it. I filled out the paperwork, put a check in with the application. Nine months later I found the envelope. I had not mailed it.

    The Stock was Enron.

  • Report this Comment On September 29, 2012, at 10:13 PM, NickD wrote:

    Just saving .10-.20 cents for every dollar you make and earning 4% a year for 45 years can land you in the millionaire club easily that's assuming you settle for 65k-70k a year I rather work harder and make 100k plus and save more./ GL kids

  • Report this Comment On May 02, 2013, at 10:31 PM, DACircles wrote:

    I used to have about 30% of my portfolio in BND moved most of it to VIG several years ago because I felt good dividend stocks were a better investment and every bit as stable as bonds in the current environment. Am I wrong about that?

  • Report this Comment On August 19, 2013, at 4:16 PM, sagitarius84 wrote:

    The metrics behind the long-term success of the best dividend stocks for investors in the past include:

    http://www.dividendgrowthinvestor.com/2011/10/five-metrics-o...

    I would say if a company has rising earnings, it can generate dividend checks for generations to come

  • Report this Comment On November 30, 2013, at 8:09 AM, deryworldscorp wrote:

    I absolutely agree to lesson number 3,

    where we sometimes but ot least forget this small important things regarding focus between earn and cash and suddenly make the snow ball on the Investment.

    we at www.deryworldscorp.asia strongly dedicated focust on that as the invenstment matters

  • Report this Comment On May 19, 2014, at 10:35 PM, DividendDiplomat wrote:

    Thank you Todd. I have benefited from the "follow cash" advice by investing in all three of the mentioned companies (PG, MCD, and LMT). Cash position and payout ratio were major decision points for that decision. I also have fallen victim to the "Chasing High Yields" lesson as I have owned companies that have slashed their dividend when times were tough (FE).

    All five of the lessons are important and hsould be considered by dividend investors while making their decisions. Keep up the goo work.

    -Dividend Diplomats

    www.dividenddiplomats.wordpress.com

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