5 keys to successful dividend investing

Dividends can be an investor's best friend. But not all dividends are created equal. Here are The Motley Fool's 5 tips to help you build a solid income-focused portfolio.

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Dividends can be an investor's best friend. But not all dividends are created equal. Here are The Motley Fool's 5 tips to help you build a solid income-focused portfolio.

In 2008 and 2009, the dividend landscape was turned upside-down. The GFC took its toll on companies from all sectors, with many cutting their dividends, including the big four banks, namely ANZ (ASX: ANZ), Commonwealth Bank (ASX: CBA), National Australia Bank (ASX: NAB) and Westpac (ASX: WBC).

Amid all the dividend cuts and suspensions, it's worth reminding ourselves of five key lessons we can use to our advantage in the future.

Lesson 1: Stock 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 brought on by the GFC. But unlike interest from term deposits, 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/yield-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 preserve cash becomes a more attractive option for companies. This is exactly what NAB did in June 2009, when it cut its dividend by almost 25% to preserve cash.

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 few years, however, if many companies are in the same boat, the stigma of a dividend cut is lessened, making it a more attractive option for other cash-strapped boards.

Lesson 2: Beware of chasing high yields

With dividend yields relatively low due strong the share price appreciation prior to the GFC, income-thirsty investors were forced to go further up the risk ladder to find agreeable yields — and many paid the price.

During the last bull market, for example, income/yield focused investors piled into real-estate investment trusts (A-REITs), formerly known as listed property trusts, which were paying handsome dividends on the back of the real estate boom. But when the GFC hit, and many A-REITs faced a liquidity crisis, the dividends took the hit.

Shopping centre operator Centro Property Group (ASX: CNP) was the sector poster child, cutting their distribution from 20.5c in June 2007 right down to zero in December 2007. Since then, they have not paid another distribution, and recently announced they have no plans to pay distributions for the foreseeable future. No wonder their share price is down over 99% from its high. Ouch.

A good rule of thumb is to be sceptical of any dividend yield more than two-and-a-half times the broader market average (currently 4% – 5%, so be wary of 10%-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. Here's looking at you Myer (ASX: MYR) and Telstra (ASX: TLS).

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.

Lesson 4: Diversification still matters

While many sectors experienced dividend cuts during the GFC, none were hurt as much as the property and finance sectors. A dividend-focused portfolio that was diversified across all sectors still likely took a hit during the financial crisis, but less so than one heavily exposed to property and finance stocks alone. 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 were wide-ranging during the GFC, your best bet is to hand-select a diversified group of strong dividend payers, rather than assuming that dividend-themed indexes and ETFs will do the trick for you.

ETFs also can have widely different franking credits attached to their dividends. For example, according to recent factsheets, the iShares S&P/ASX High Dividend (ASX: IHD) had an implied franking credit of 68.70% while the SPDR MSCI Australia Select High Dividend Yield Fund (ASX: SYI) had an implied franking credit of 79.90%.

Also check how frequently the ETF can rebalance. The Vanguard Australian Shares High Yield ETF (ASX: VHY) rebalances quarterly while the iShares S&P/ASX High Dividend Yield rebalances semi annually. This can impact their ability to respond to changes in dividend payouts of the underlying holdings. The ETF may be forced to hold many stocks that either stopped paying dividends or drastically reduced their payouts until the ETF is allowed to rebalance.

Wrapping it up

These five keys to successful dividend investing can help you build a diversified portfolio of hand-selected dividend payers, that pay fully franked dividends with above-average but modest yields, well-covered by plenty of free cash flow. Pair this group with some high paying term deposits, and you'll have built yourself a solid income-focused portfolio that can help you achieve good profits without undue risk.

This article, written by Todd Wenning, was originally published on the Fool.com. Contributor Mark Tobin has updated it. Mark does not own any of the shares mentioned in the above article. Mark works for Wilson Asset Management, and that firm or its clients may own any of the shares mentioned above. These positions can change at any time. The Motley Fool has a fine disclosure policy.

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