In this low interest rate environment, yield-hungry investors have flocked to dividend stocks to boost their income. To get a top-level view of the current market for dividend stocks, we recently spoke with Daniel Genter, CEO and chief investment officer of RNC Genter Capital Management, who explained the investment process he uses to identify the most promising dividend-paying names for RNC Genter Dividend Income Fund (GDIIX). Morningstar currently ranks the fund in the top 2 percent of large-cap value funds on a trailing one-year basis, which shows Genter’s strategy has produced solid returns while maintaining an attractive level of current income.

Ben Shepherd: Please describe your fund’s investment strategy.

Daniel Genter: We run a high-dividend strategy, so it is distinctly focused on generating high dividends. The latter part of that sentence may sound a tad obvious, but other high-dividend funds are often value-oriented strategies that select stocks which happen to pay attractive dividends. In other words, constructing a portfolio with stocks to produce an absolute level of dividends isn’t necessarily one of their goals.

In our screening process, our first step is to look at absolute levels of dividends to ensure a stock will fulfill our yield parameter, which is a minimum yield of 2.5 percent. In addition to maintaining a minimum yield, we want the whole portfolio to produce an absolute average income level that is double that of the S&P 500. We know we can’t always target a specific number because of market fluctuations, but over a full market cycle we should be able to double that income.

We also want the company to have paid a dividend for at least five years without cuts, and we like to see dividends rising by about 8 percent to 10 percent a year. Our goal is for the average stock in our portfolio to have a payout ratio under 60 percent.

The next part of our process is to determine whether a company’s dividend has the same level of integrity that investors would demand from a bond coupon payment. This step is somewhat unique because it requires us to analyze these companies from the perspective of whether we’d be willing to buy bonds that they’d issue.

This involves a balance sheet analysis, as opposed to an income statement analysis. One of the metrics we look at is the free cash flow ratio to straight debt obligations. We also require a company’s straight debt to be investment grade. Indeed, if one of our holdings has its debt downgraded below investment grade, then we automatically sell the stock. Additionally, we look at cash flow coverage and total debt loads. Our process requires a company to have a debt-to-equity ratio of less than 40 percent.

We regard the dividend payment as if it were a coupon payment, so we need to feel comfortable with the straight debt because stockholders are subordinate to bondholders. If a company has any problems with its straight debt, then they’re going to cut the dividend to stave off a downgrade or avoid an eventual default. And even if they don’t cut the dividend in such a scenario, they’re still not going to have the excess cash flow necessary to support any increases in the dividend.

So when you buy a high-dividend stock, you’re holding the company’s stock to a higher standard than even its bonds. That’s because you’re not only expecting the company to maintain that high dividend, you’re also hoping for it to rise every year. That’s akin to buying a variable-rate bond with a rate that only goes up.

The third part of our process is to strip away the balance sheet and the dividend and simply arrive at a valuation of the company’s stock.

When we consider adding a stock to our portfolio, it must fulfill the criteria in each of these steps or it won’t make the cut.

Ben: What factors do you look at to gauge potential dividend growth?

Daniel Genter: A company must have a reasonable payout ratio. I don’t set an absolute number there because that’s going to depend on the industry; you can’t set the same guidelines for a utility that you would for a technology company. That’s why we look at payout ratios from a total portfolio standpoint, with the goal of maintaining an average payout ratio below 60 percent. At present, our portfolio has an average payout ratio of about 40 percent, while the S&P 500 has a total payout ratio of about 26 percent.

We also look for companies that generate significant free cash flow. The reason we focus on free cash flow versus just earnings is because free cash flow is where the rubber meets the road. Of course, you can’t ignore earnings entirely because a company’s board of directors is always going to use the firm’s payout ratio to earnings to guide its dividend policy.

Dividend growth is key because most of our clients don’t want to rely on capital appreciation to fund their lifestyles. Instead, they use cash flow as a reliable way to project their income. A portfolio that yields 4 percent with an average dividend increase of 8 percent to 10 percent per year produced an increase in cash flow of over 60 percent over the past five years or so.

For the typical income investor, the money that flows out of their portfolio and into their checking account is crucial, and the reinvestment rate from bonds can impair that cash flow. In a diversified portfolio of dividend-paying names, an investor should be able to maintain cash flow and even compound it by 8 percent to 10 percent annually if they’re paying attention to the right parameters. So a high-dividend portfolio can grow cash flows quickly and at many times the level of inflation.

Ben: There’s been a lot of interest in dividend strategies over the last few years, and most dividend stocks have been bid up. Can you still find value in dividend stocks?

Daniel Genter: That’s where selectivity becomes really important. An income investor is not well served by a large mutual fund that holds hundreds of companies because not all of those companies are going to be able to increase their dividend at the same magnitude as the top performers.

If you’re going to maintain your current yield, you’ll need dividends to increase at the same rate at which share prices appreciate. Assuming a constant price-to-earnings ratio (PE) or a PE that regresses to the mean, then the share price should rise in line with the magnitude of earnings increases. Therefore, you want to look at companies that consistently make an effort to maintain their payout ratio. If they’re maintaining their payout ratio, then dividend increases should increase in line with their earnings.

If current yields drop, that reduces the universe of attractive securities for new investors, but that’s not an adverse scenario for investors who already hold shares of a stock with a declining yield. The current yield may be going down based upon the appreciated price of the stock, but the actual dollar amount of dividends being paid remains the same. Ideally, you want to have a constant payout ratio along with a rising dividend. These types of stocks are still out there, but you’ve got to be very selective to find them. That means building a portfolio with 30 or 40 names versus one that has more than 100 stocks because there aren’t too many companies that fulfill the aforementioned criteria.

Ben: Apple (NasdaqGS: AAPL) recently started paying a dividend. Will we see more companies start to make payouts?

Daniel Genter: We’re already seeing that. Almost 390 of the S&P 500 companies are now paying dividends, and last year about 15 started paying dividends for the first time. This momentum is happening for a couple of reasons.

First, investors are now focused on building portfolios that reduce risk and provide steadier returns. The only real way to do that consistently in the equity market is to produce more cash flow. If you start off at the beginning of the year generating 3 percent to 5 percent in cash flow, then you’ve already locked in about 50 percent of an 8 percent to 10 percent annual return. And if dividends grow, then you’re going to enjoy an even greater return.

Many investors come to us and say they’re using dividend stocks as the foundation of their portfolios, even though they know that they might not get 100 percent of the broad market’s upside. But their portfolios will capture 85 percent to 90 percent of the market’s upside and only 70 percent of its downside. Meanwhile, they receive a steady stream of dividend income while they wait for their stocks to appreciate.

The second reason underpinning this trend toward payouts is the huge wave of baby boomer retirees who need income. Neither bonds nor money market funds offer enough income to sustain their lifestyle, and the market’s volatility since 2000 has taught them that they can’t count on capital gains. They’re looking for predictability and cash flow, but they don’t want to invest in hedge funds or other investment products that they don’t understand, so dividend stocks are the most attractive option. Most boards of directors understand this demographic shift and are willing to enhance shareholder value by paying out dividends.

Ben: What impact might rising interest rates have on dividend stocks? That’s obviously more of a risk for bondholders, but utility stocks don’t respond well to higher rates and they’re traditional dividend payers.

Daniel Genter: Rising interest rates are generally positive for dividend stocks. Some traditionally defensive areas like utilities might be impacted by rising rates, but a market selloff of dividend stocks would be more of a kneejerk, psychological reaction than one based on the fundamentals.

We’re at a crossroads in the bond market right now because rates are low, and it’s quite evident that there’s going to be an inflationary headwind over the next three years or so. Income investors have to maintain a very long-term outlook and accept the fact that a bond portfolio is really just going to be a bomb shelter.

The chance of bonds producing significant appreciation right now is extraordinarily low and the math on that is pretty straightforward. I don’t think people will abandon bonds, however, because they’ll still want to have that bomb shelter.

But when it comes to deploying new assets, an atmosphere of rising rates makes securities that generate a higher rate of income very attractive. Dividend stocks are largely immune to rising rates until the point when bonds offer better, safer returns than equities. But the practical reality is that the first push toward rising rates is generally good for equity markets because these rates are being driven higher by expectations for above average growth.

Ben: If the Bush tax cuts sunset, that means dividends’ more favorable tax treatment could disappear. Will we see a rush out of dividend stocks if that were to happen?

Daniel Genter: The vast majority of investors in high-dividend stocks aren’t very focused on the tax situation.

When the Bush tax cuts came into effect, there wasn’t a massive rush into dividend stocks. As a matter of fact, it took a recession and falling interest rates to push investors into dividend stocks.

I don’t think you’ll see a massive exodus out of dividend stocks for two reasons.

One, unless another asset class is incentivized through lower taxes or some other mechanism, there’s no reason for people to rotate out of dividend stocks since they’d still need that source of income.

The other reason, which is probably more significant, is that although everyone’s scared that the maximum effective dividend tax rate will rise to 39.6 percent, there actually will be few individuals who pay that rate.

On an individual basis, you need to have an adjusted gross income of over $330,000 to reach the 39.6 percent bracket. Most people, after all their deductions, have adjusted gross incomes at a level where dividend income isn’t likely to fall into that 39.6 percent bracket, particularly retirees. So the sunset of the Bush-era tax cuts isn’t going to have too onerous an impact on the typical income investor.

Ben: Are there any sectors offering particularly attractive opportunities for dividend investors?

Daniel Genter: Ironically, the technology sector is becoming increasingly well represented among the universe of dividend payers. And payouts from the financial sector are also starting to recover from the downturn. Wells Fargo’s (NYSE: WFC) stock now yields 2.6 percent, and JPMorgan Chase (NYSE: JPM) and BlackRock (NYSE: BLK) are both paying decent dividends. Health care is also attractive right now, and it will probably remain undervalued as a sector until the health care reform situation is sorted out.

We’re also fairly positive on consumer staples companies, particularly stocks such as Altria (NYSE: MO), Philip Morris International (NYSE: PM) and Molson Coors Brewing (NYSE: TAP), which are all very strong, consistent dividend payers.