A successful dividend investing strategy must focus on a number of key factors—and avoid these common mistakes

Many Successful Investors have come to share our high regard for a sound dividend investing strategy.

It takes a lot of success and good-quality management for a company to have the cash flow and the determination to declare and pay dividends every year for five or 10 years or more. It’s not something you can create at the spur of the moment.

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A successful dividend investing strategy should consider the dividend payout ratio

One of the best ways to judge whether a company will keep paying its dividend, or even increase it, is its dividend payout ratio. This measures what portion of a company’s earnings, or perhaps cash flow, is allotted to paying dividends.

If a company keeps its payout ratio fairly steady, say at 30% of cash flow, and its cash flow grows, the amount you receive in dividends should also grow. However, if a company must keep paying out a larger and larger percentage of its cash flow just to maintain the dividend, it’s reasonable to wonder whether the company’s business is in decline—and the dividend is in danger of being cut.

You need to look at other factors, as well, of course. The company may be going through a low cycle in its industry, or have a temporary problem it has a good chance of solving.

Any dividend investing strategy needs to recognize these tips

Good dividend stocks are a valuable component of any sound investing portfolio. And here are six tips for picking the best Successful Investor dividend stocks.

• Dividends are a sign of investment quality. For a true measure of stability, focus on companies that have maintained or raised their dividends during economic and stock market downturns.
• The best dividend stocks dominate their markets. Our reasoning, besides brand recognition, is that major companies can influence legislation, industry trends, etc. to suit themselves. Minor firms can’t do that.
• The best dividend stocks often feature hidden assets. For instance, when a company buys real estate, the purchase price goes on its balance sheet at the historical value of the asset. Over a period of years or decades, the market value of that real estate may climb substantially. But the historical purchase price remains unchanged on the balance sheet.
• A history of dividend payments is one thing that all the best dividend stocks have in common. One of the best ways of picking a quality dividend stock is to look for companies that have been paying dividends for at least 5 to 10 years.
• Dividends can grow. The best dividend stocks like to ratchet their dividends upward over time—holding them steady in a bad year, and raising them in a good one.
• Watch out for unusually high dividend yields. A high yield can sometimes be a danger sign rather than a bargain.

The three-part foundation of a dividend investing strategy

Even what seem to be the best dividend payers can go through dividend droughts. Those are periods when they have to cut or quit paying dividends due to setbacks within their company, their industry or the economy as a whole.

That’s why you still need to observe our Successful Investor approach, even when confining your investments to stocks with strong dividend records. The three parts of our philosophy are:

1. Invest mainly in well-established companies.
2. Spread your money out across most if not all of the five economic sectors (Manufacturing & Industry, Resources & Commodities, the Consumer sector, Finance and Utilities).
3. Downplay or avoid stocks that are in the broker/media limelight.

Bonus tip: Is a “dividend capture” strategy a dividend investing strategy worth using?

A “dividend capture” strategy is a trading technique of buying a stock just before the dividend is paid, holding it just long enough to collect the dividend, then selling it. If you can sell it for as much as you paid for it, you have “captured” the dividend at no cost, other than the transaction costs.

To do this, you would buy a stock just before the ex-dividend date, so that you would be a shareholder of record on the record date, and would receive the dividend. Because the stock generally falls by the amount of the dividend on the ex-dividend date, the strategy then calls for you to wait for the stock to move back to the price where you bought it before the ex-dividend date. At this point, you sell the stock for a break-even trade.

In theory, this can pay off when stock markets are rising. Of course, any strategy that involves buying shares can pay off when stock markets are rising. However, you have to pay a brokerage commission to buy the shares, and a commission to sell. The commissions can eat up much of the dividend income. In fact, they may even exceed the dividend income.

In the end, a dividend-capture strategy may only really have appeal for securities dealers or brokers who are executing huge trades with very low transaction costs. They, particularly corporations, may also have tax benefits. But the average investor has little chance of making a significant profit.

Some investors complain that dividend-focused portfolios sacrifice diversification. Do you agree? How have you avoided this issue?

Have you used a dividend capture strategy? What kind of results did you get?