DGI Lesson 20: My ‘Quality Snapshot’ Grading System

Introduction

DGI Lesson 14 presents a comprehensive method for scoring dividend growth stocks.

Sometimes, though, you just want a quick take on a company’s quality.

For that purpose, I developed Quality Snapshots, which take five company quality ratings from various sources, assign points to their rating levels, and add them up to a single score that gives you a fast way to judge a company’s quality.

Sources of Company Ratings

I have come to trust and respect these sources over the years, and I use them to create the Quality Snapshots:

That gives me five factors to consider. At the bottom of this article, I present detail behind each provider’s ratings, so you can look at that information to understand how each one works on its own.

Quality Snapshot Grading System

To pull the individual sources together, I developed a straightforward point system for each factor. In this table, NA means “not applicable.”

As you can see, each factor can get 0-5 points. A few individual grades are not available if a factor does not have enough levels itself to assign each one its own point score.

To create the Quality Snapshot for a company, I total up its quality points. The highest possible total is 25 points.

To interpret those totals. I use the following ranges.

Obviously, anyone can adjust the point system and interpretations to suit themselves.

Examples

Here are two examples of the Quality Snapshots in action. The first example shows a highly-rated dividend growth stock, and the second example is of a low-rated one.

Example 1: Johnson & Johnson

Johnson & Johnson is as high-quality as a company can get.

All of JNJ’s individual ratings are in the highest category from each source. Therefore, each of the individual scores is 5 points, and the total is 25, which is the highest score a company can get. (Disclosure: I own JNJ.)

Example 2: Ventas

Ventas is a REIT that I used to own. But on the Quality Snapshot, it gets mediocre grades almost across the board, and when you add everything up, I come to the conclusion that it is too speculative a stock for my dividend growth investing.

Let’s go through Ventas’ ratings to illustrate how they work.

  • Value Line Safety Grade – Value Line gives Ventas a 3 on its 5-point scale, which is acceptable by itself, but not outstanding.
  • Value Line Financial Strength Grade – VL’s grade of B+ sounds pretty good if you are in school, but when you examine their categories, you see that it is actually their 5th-worst grade out of 9 levels. It’s more like a “D” in school.
  • S&P Credit Rating – I only invest in “investment-grade” companies. S&P’s BBB-level grades are investment-grade, but they are on the lowest rung just above speculative.
  • Morningstar Moat – Morningstar awards Ventas no moat, meaning that they do not see sustainable competitive advantages. I don’t penalize companies completely (i.e., 0 points) for not having a moat, but it’s not an attractive situation either.
  • Simply Safe Dividends Safety Grade – This is Ventas’ best showing, landing in SSD’s second-highest category.

None of Ventas’ individual grades is disqualifying by itself, but when you add up the points, you realize that there are several question marks about this company.

I want really good companies that I don’t have to worry about. Ventas just does not seem to measure up to that standard. And in fact, it has not raised its dividend payout over the last nine quarterly payouts.

Background Materials

Here are the sources of the quality ratings that I use. These are all from commercial information providers, not “sell-side” analysts or their stock ratings.

While I don’t always agree with individual ratings on particular stocks, I trust the objectivity of these sources, because they make their money from data accuracy and intelligent interpretation, not from stock trading or trying to induce others to trade.

1. Value Line Safety Grade

Here is how Value Line describes these grades:

The Safety™ Rank measures the total risk of a stock relative to the approximately 1,700 other stocks covered in The Value Line Investment Survey®.

Value Line’s grades range from 1 through 5. I award points to the top four categories, but the lowest category gets 0 points.

2. Value Line Financial Strength Grade

Value Line classifies 1,700 companies’ Financial Strength ratings from A++ to C, in nine steps. The lowest grade is reserved for companies experiencing serious financial difficulty. Balance sheet leverage, business risk, the level and direction of profits, cash flow, earned returns, cash, corporate size, and stock price, all contribute to a company’s relative position on the scale. The amount of cash on hand, net of debt, is also an important consideration.

These grades range from A++ to C. I award them points ranging from 5 points for A++ down to 0 points for any grade less than B.

3. S&P Credit Rating

In the image below from S&P, the colored lines along the left side correspond to the points scheme shown earlier in the article.

The yellow-highlighted text at the bottom explains S&P’s addition of a plus sign “+” or minus sign “-” to most of the ratings.

That’s how a stock can have a rating of A+ or BBB-.

BBB- is the lowest rating possible for an investment-grade security.

Lower-rated stocks (BB+ or below) have “significant speculative characteristics,” and I award them no points.

4. Morningstar Moat Rating

An economic moat refers to a firm’s sustainable competitive advantages. A company with an economic moat can fend off competition and earn high returns on capital for years to come.

Morningstar has identified five sources of moat.

  • Customer switching costs keep customers from changing from one product to another.
  • Network effect means the value of a product or service increases as more customers use it.
  • Intangible assets include intellectual property rights, government licenses, and brand identity.
  • Cost advantages allow a company to undercut competitors or achieve higher profitability.
  • Scale and size benefit companies in industries that only support a few participants.

Morningstar awards moat ratings as follows:

  • Wide moat – Company can benefit from its competitive advantages for more than 20 years. I give 5 points for a wide moat rating.
  • Narrow moat – Company can benefit for 10 years. I give 4 points.
  • No moat – Company has no competitive advantage or one that will not last long. I assign 2 points (rather than 0), because some companies can still succeed simply based on customer preferences.

5. Simply Safe Dividends Dividend Safety Rating

Here is how Simply Safe Dividends describes their dividend safety scores.

Our Dividend Safety Scores were designed to help dividend investors like you identify and avoid companies that appear to be riskier sources of income. …
Simply put, companies that end up cutting their dividends have typically been under stress for a while and need to preserve cash. They have likely experienced a meaningful decline in earnings, their balance sheets might be strained with too much debt, and their payout ratios have often jumped to levels that provide less financial flexibility.
Our Dividend Safety Score system takes into account more than a dozen fundamental metrics that influence a company’s ability to continue paying dividends. Some of the metrics scrubbed are a company’s:

  • Payout ratios
  • Debt levels and coverage metrics
  • Recession performance
  • Dividend longevity
  • Industry cyclicality
  • Free cash flow generation
  • Recent sales and earnings growth
  • Return on invested capital

Dividend Safety Scores are … updated daily using professional data feeds, and primarily change when new earnings reports are released. Scores are kept completely up-to-date to ensure you always have the most timely and accurate information in front of you.

SSD’s scoring system looks like this:

I assign SSD’s top four categories 5, 4, 3, and 2 points respectively. I give no points for a 0-20 rating.

— Dave Van Knapp

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