Keys to Successful Dividend Investing?

5 Keys to Successful Dividend Investing

By Todd Wenning January 25, 2010

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 want to learn more about Dividend Investing just go to
InvestorRules.com and sign up to ( free for now) membership area

Enjoy

Eric$

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