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, in 2009, according to Standard & Poor's, another 804 dividend payments were cut by public companies -- 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: Dividends are a privilege, not a right
The first and most obvious lesson -- that dividends are not guaranteed -- was a truism most people ignored in the years leading up to the dividend crisis. 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.

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, because of 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 (NYSE: SPG), 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 1.9%, so be wary of 4.7%-plus). Anything beyond that amount implies that either the market has concerns about the company's ability to grow, or that the stock price has fallen for a good reason.

In today's market, that means I would approach commercial printer R.R. Donnelley & Sons' (NYSE: RRD) 5.7% dividend yield with caution. Even though the dividend is currently covered by free cash flow, it isn't covered by earnings and the company's interest coverage ratio has been cut in half over the past four years (currently 3.2 times), meaning they aren't generating as much operating profit (EBIT) to cover their interest expenses these days.

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 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 company paid in cash dividends each year. If that figure is consistently less than free cash flow, it's a good sign that the company has enough cash to maintain its current dividend. Five names that fit this bill today are:



Free Cash Flow
Payout Ratio

Pfizer (NYSE: PFE)



Wal-Mart (NYSE: WMT)



Yum! Brands (NYSE: YUM)



Chevron (NYSE: CVX)






Data provided by Capital IQ, as of Nov. 3, 2010.

Lesson 4: Diversification still matters
While many sectors experienced dividend cuts over the past two years, none was 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. In fact, technology companies as a group pay more in dividends (9.2% of the S&P 500 total) and have higher average yields (1.9% versus 1.4%) than financials!

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 invested in the likes of General Electric, Dow Chemical, and Alcoa, 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
These 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 more help building a complete portfolio of great stocks -- including good dividend payers -- it's worth taking the time to learn more about our Million Dollar Portfolio service, which is opening its doors again to new members. To get more information about Million Dollar Portfolio, simply enter your email in the box below.

This article was originally published Jan. 25, 2010. It has been updated.

Fool analyst Todd Wenning recommends Salt: A World History by Mark Kurlansky for fellow history geeks. He does not own shares of any company mentioned. Pfizer and Wal-Mart Stores are Motley Fool Inside Value picks. Chevron is a Motley Fool Income Investor selection. The Fool owns shares of Wal-Mart Stores and Yum! Brands.

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