Three Dividend Stocks with a Perfect Risk Score

A good system continues to improve itself. I maintain an extensive database with a minimum of 10 years of information on each of the 110+ stocks that I track. This data is gathered from various sources deemed reliable. Most data is generic and can be pulled from various sites. That is except some S&P risk and quality information (RQ).

Gauging the relative risk of one stock compared to another is important when deciding which stock to buy or how much to weight a stock within your portfolio. Recently, during a scheduled site maintenance event on my broker’s site, S&P reports were temporarily unavailable. This made me question if I really wanted to rely on propriety financial information that was not readily available from multiple sources. Ultimately, I decided it was not a good thing. To remedy this situation, the RQ portion of my risk calculation was modified as such:

For the Risk portion, I opted to focus on consecutive dividend increases. The logic here is the longer a company raises its divided, the more committed it is to dividend increases and is less likely to stop unless dire financial circumstances dictate it. Instead of relying on S&P’s Qualitative Risk Assessment (Low, Medium and High) to assign a risk rating, I will now use the following to assign the A, B or C risk rating:

• A Risk Rating is assigned to companies that have increased their dividends for greater than 25 years.
• B Risk Rating is assigned to companies that have increased their dividends for 15-25 years.
• C Risk Rating is assigned to companies that have increased their dividends for less than 15 years.

As for the Quality portion, I decided on use the company’s financial quality by focusing on Free Cash Flow payout and Debt to Total Capital. Instead of using S&P’s Quality Ranking (A+, A, A, B+, B, B-, C, D and Not Ranked) to assign a quality rating, I will now use the following to assign the 1, 2 or 3 quality rating:

• 1 Quality Rating is assigned to companies if their Free Cash Flow Payout % is less than 60% and if their Debt to Total Capital is less than 45%.
• 2 Quality Rating is assigned to companies if the sum of their Free Cash Flow Payout % plus their Debt to Total Capital is less than 100%.
• 3 Quality Rating is assigned to companies if the sum of their Free Cash Flow Payout % plus their Debt to Total Capital is greater than 100%.

Making this change to the 110+ companies I track. Here is what I found:

• Overall the new method produces lower risk scores.
• The overall risk rating on my income portfolio went from 1.78 (medium) to 1.68 (medium).
• High risk stocks went from 7 stocks to 4 stocks.
• Medium risk stocks went from 77 stocks to 54 stocks.
• Low risk stocks went from 27 stocks to 53 stocks.

Excellent, low risk stocks evaluate the same under both systems. For example, the following three companies had a perfect 1.00 score under both systems:

• Johnson & Johnson (JNJ) – Analysis
  
• Procter & Gamble Co. (PG) – Analysis
• Wal Mart Stores Inc. (WMT) – Analysis

While 60 companies improved their position, 19 companies ratings slipped under the new system. Below are some of the more notable changes:

• Pepsico Inc. (PEP) went from a 1.00 (low) to 1.25 (low) – Analysis
• United Technologies Corp. (UTX) went from a 1.25 (low) to 1.50 (low) – Analysis
• Exxon Mobil Corp. (XOM) went from 1.50 (low) to 1.75 (medium)
• Colgate Palmolive Co. (CL) went from 1.50 (low) to 1.75 (medium)
• International Business Machines (IBM) went from 1.75 (medium) to 2.00 (medium)

The RQ portion of the risk rating is 50% of the calculation. The remaining two pieces are Current Price vs. Calculated Price and Dividend Yield. These are unchanged and their part of the risk rating calculation is discussed in Refining Risk Measurement Of Dividend Stocks.

Disclosure: Long JNJ, PEP, PG, UTX, WMT. See a list of all my income holdings here.

Comments

[starvin sar...:]

Great research, practical and simple. Have you found and ETF or a CEF that has these picks as the highest percentage of their holdings? Also have you done any correlation research on these? Also if you were to combine them into a portfolio (I have seen your selection on your site) which of them would you combine with these picks. Thanks for your hard work

Starving Sergeant

Oct 07 07:42 PM

[Shishir Nigam:]

I agree with a simple approach to assessing the historical capability of a firm's ability to maintain its dividend.

However, I question the utility of an approach that relies mainly on historical trends in a company's dividend policy. Unfortunately, in the market that we are in, it's hard to make a bet on company stability without examining the business model of firm as a whole and whether that is sustainable. For example, just over this downturn, many companies which were thought to have rock solid dividends, turned around and slashed away their dividends in a bid to conserve cash. Examples include Dow Chemicals (DOW), GE, Pfizer (PFE), Motorola (MOT), Textron (TXT), CBS Corp (CBS). For each of the above-mentioned companies, I think few people prior to the downturn, would have bet their money on these guys cutting their dividends. At that point in time, before the crisis, it is very likely that most of these companies would have attained the highest rating through your approach.

The additional evaluation of fundamental ratios definitely strengthens the approach you mention though. Without being overly critical, I'd suggest that an examination of the sustainability of a company's business model under times of stress, might be very useful in setting apart the real rock solid dividend providers from the other weaker companies. Would love to hear your take on this.

For more analysis, check out my blog: youngandinvested.com

Oct 08 06:50 AM

[David Van K...:]

I have done a lot of research into, and thinking about, the issues presented here. What I have found is that there are various approaches that can and do work. For example, in my "Top 40 Dividend Stocks for 2009" (the 2010 edition will be out in January), I use a completely different system from D4L's. I put much less weight on the payout ratio, because I have concluded that different payout ratios work for different companies, depending on their capital structure and other factors. After all, speaking loosely, REITs must distribute 90% of their profits to maintain their unique tax status. And in their business, such a distribution ratio works.

But my point here is not to debate the fine points of a system for increasing the odds that a dividend is sustainable and likely to be increased regularly. My point is to underscore the importance of HAVING a system for drawing those conclusions. If you are a dividend investor--for wealth accumulation or current income--pay attention not only to the current yield (which I'm afraid is where some people stop), but also to its sustainability and the likelihood that the company is going to increase it significantly over time. Examine the company's financial profile and prospects. Bottom line, make the company "prove itself" that it is a worthy candidate for your precious dividend portfolio.

BTW, I agree with Shishir Nigam that part of this inquiry should include a qualitatitve assessment of what I call the company's "Story." How does it make money? What are its strategies? Is it dominant in its markets? What is its business model? Does that make sense to you? Follow Peter Lynch's advice: If you can't understand how a company makes money, don't invest in it, no matter what its numbers.

Oct 08 08:48 AM

[Dividend Gr...:]

I think that if you have a strategy to pick good dividend growth stocks, it should take care of things like dividend cuts, diversification, dividend reinvestment and buying and selling stocks. I don't like assigning "risk points" to stocks however, as I am always afraid that using shortcuts would prevent me from seeing problems in the future.

As for the dividend payout ratio, I agree that the dividend sustainability of certain types of stocks like REITs should be adjusted to reflect the fact that they are required to distribute most of their earnings out to shareholders.

The payout ratio in general has prevented me from buying stocks like BAC, USB, PFE, which ended up cutting their distributions. I understand that investors should expect changes in the fundamentals of the companies they have invested with. Also, no matter how great of a stock picker you are, and how awesome your system is, you would still have at least one dividend cut/year for a portfolio of 30-40 stocks. If you hold less than 10-15 stocks in a portfolio this dividend cut would really hurt, which is why I advocate strong diversification.

I agree with David that most investors seem to hang on to the highest yielding stocks, without considering whether dividend payment is sustainable or not.

Oct 08 10:04 PM

[No Free Cake:]

You might want to consider including "price over time" in your metrics. It's great owning stocks which increase dividends, but, if its price deteriorates over time you are just treading water or worse. Sure there will be swings, but, just a glance at a long-term price chart will tell you if you own an appreciating asset or a depreciating one.

For example, look at a price chart for KO, which you own, since 2000. Or, to a lesser extent, WMT since 2000. Do they look like companies that are healthy and growing? Quote any statistics you want saying they are - in the long term if the price doesn't reflect that it doesn't matter.

If a company is steadily raising its dividends it should eventually "force" its price up. After all, if a dividend keeps growing but the price stays the same the yield will get so high that it should (will) bring in more investors. If the increasing dividend isn't bringing in new money, something is amiss.

Disclosure: I don't own KO or WMT but do own PEP.

Oct 08 11:33 PM

[sethmcs:]

What about preferred stocks? Most have much more attractive dividends that are protected by coventants. Some preferreds are convertable into common as well.

Oct 08 11:43 PM

[searcher:]

Worthwhile read, thank you. I’m sure many of us would be interested in an article from you specifically addressing your sell discipline.

Oct 09 12:52 PM