5 Keys to Successful Dividend Investing

In 2008 and 2009, the dividend landscape was turned upside down. In the fourth quarter of 2008, 288 companies cut their payments. In 2009, 804 dividend payments were cut, costing investors $58 billion. These dividend cuts and suspensions over the past two years have reminded us of five lessons that we can use to our advantage today.

Lesson 1: Stock dividends are not a right

The first lesson is the most obvious: the dividends are not guaranteed. Yet most people ignored this in the years leading up to the subprime crisis. Contrary to what happens with bondsa board of directors can choose whether or not to pay a dividend in cash to its shareholders.

There are obvious incentives to maintain or regularly increase dividend payments : they help attract investors and are a sign of financial strength. But in times of severe uncertaintiesParticularly in a credit-fuelled panic, cutting dividends to increase or preserve liquidity becomes a more attractive option for companies. This is exactly what Pfizer (NYSE: PFE) did when it cut its dividend in half to finance its acquisition of Wyeth.

When a company cuts its dividend, it usually signals an inability to manage its finances. It's a wake-up call. 

Lesson no. 2: Beware of high yields

Lnterest rates and low market profitability that have prevailed over the last decade or so have forced income-seeking investors to move further up the risk scale. Unfortunately for them, many have paid the price.

We experienced this during the American real estate boom, with companies paying their shareholders handsomely.. When properties stopped generating as much cash, due to rent arrears or the inability to pay interest on debt as a result of rising interest rates, dividends took the hit. 

A good rule of thumb is to be skeptical about any performance of higher dividend at 2.5 times the market average (currently 2%, so beware of 5% and over). Anything in excess of this amount implies that either the market has concerns about the company's ability to grow, or that the share price is too high. has fallen sharply (for good reason).

S&P 500 historical performance

In June 2008, for example, Bank of America (NYSE: BAC) was yielding over 10%, at a time when the market average was around 2% to 3% - a good indication that the dividend was far from assured. Indeed, it wasn't...

BAC dividend

Date			Dividend
Nov 30, 2011	0.01 Dividend
Aug 31, 2011	0.01 Dividend
Jun 1, 2011	0.01 Dividend
Mar 2, 2011	0.01 Dividend
Dec 1, 2010	0.01 Dividend
Sep 1, 2010	0.01 Dividend
Jun 2, 2010	0.01 Dividend
Mar 3, 2010	0.01 Dividend
Dec 2, 2009	0.01 Dividend
Sep 2, 2009	0.01 Dividend
Jun 3, 2009	0.01 Dividend
Mar 4, 2009	0.01 Dividend
Dec 3, 2008	0.32 Dividend
Sep 3, 2008	0.64 Dividend
Jun 4, 2008	0.64 Dividend
Mar 5, 2008	0.64 Dividend

Whoever bought BAC in June 2008 for its generous yield, ended up with a stock that not only paid almost no dividend 9 months later, but whose share price plummeted during the same period:

Lesson 3: Focus on cash flow, not compensation

Without sufficient real cash, the company must finance its dividend either through debt or the sale of shares, which is no guarantee of sustainability. To determine whether or not a dividend is sustainable, first look at the company's cash flow from operations over the last five years. Then, subtract capital expenditure for each of these years. What remains is considered "free cash flow", which the company can use to pay dividends or buy back shares. Next, look at how much the company paid in cash dividends each year. If this figure is always lower than free cash flow, it's a good sign that the company has enough cash to maintain its current dividend.

If the company is to pay out a regular dividend and grow its dividend, it must have a dynamic business model that generates an ever-increasing level of cash flow. Unfortunately, most companies have a degree of variability in which cash earnings do not progress steadily. The way in which a company manages to absorb these ups and downs is reflected in its free cash flow distribution. Free cash flow tells you how much money the company has left over after paying normal operating expenses. It's the money used to pay for acquisitions, debt obligations and other expenses. dividends ! If your free cash flow is too low, you may well question your ability to pay a dividend.

Lesson no. 4: Diversification, again and again

While many sectors have seen dividend cuts over the past decade, none has been hit as hard as the financial sector, which at one point accounted for 30% of all dividends. dividend income of the S&P 500. It's now down to 9%, according to S&P analyst Howard Silverblatt. Eespite the sluggishness in financial services, 33 of the 34 consumer goods companies of the S&P 500 paying dividends in 2009.

Lesson no. 5: Selectivity is key

Manually select a diversified group of strong dividend payers, rather than investing in a dividend index via an ETF.. In December 2008, the WisdomTree Equity Income Fund ETF (DHS) invested heavily in General Electric (NYSE: GE), US Bancorp (NYSE: USB) and Wells Fargo (NYSE: WFC). These reduced their gains in the following months. To make matters worse, since the ETF is only allowed to rebalance once a year, ETF owners were forced to hold stocks of many companies that had either stopped paying their dividends or sharply reduced their payouts.

It's in the pocket

The five keys to success for investing in dividends will help you build a diversified portfolio of hand-picked dividend payers with above-average, but modest yields well covered by the abundance of free cash flow. With a few obligations and a handful of real estate investment trusts, you'll have built an income portfolio that can help you earn solid profits without undue risk.

Sources:

http://www.fool.com/investing/general/2010/11/03/5-keys-to-successful-dividend-investing.aspx

http://www.dividend-growth-stocks.com/2011/10/13-higher-yielding-lower-debt-dividend.html

http://www.multpl.com/s-p-500-dividend-yield/