What Are The Highest Quality Dividend Growth Stocks?

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Includes: ADP, JNJ, KO, MMM, MRK, MSFT, NKE, ORCL, PFE, PG, WMT
by: David Van Knapp

Summary

Many dividend growth investors seek the highest-quality companies.

Independent data providers such as S&P and Morningstar offer various rankings of quality factors.

A simple scoring system using independent factors is applied.

11 companies got perfect scores.

Many dividend growth investors try to stick to really high-quality stocks. There are many ways to define quality, of course, but many investors utilize independent gauges of quality as part of their process.

In this article, I employ four of the most widely used quality indicators:

  • Value Line's Safety Rank0
  • Value Line's Financial Strength rating
  • Morningstar's Moat rating
  • S&P Credit ratings

I applied the indicators to stocks in David Fish's Dividend Champions, Contenders, and Challengers document (CCC), which requires five straight years of increasing dividend payouts to be listed.

You will find complete descriptions of the proprietary quality factors at the end of the article.

Scoring System

To identify the highest-quality companies, I used only the top grade levels for each of the four factors. Companies falling below those levels on any factor were eliminated.

The top companies got 5 points on every factor for a maximum score of 20. The lowest qualifying companies got 4 points on every factor for a total of 16.

I often use 5-point grading systems. For this exercise, qualifying companies must be in one of the top two grading levels on every factor. That is, they must get 4 or 5 points on each of the four factors. A 3 on a single factor knocks a company out.

These are stringent tests. Many well-known companies of undoubted quality did not make the cut. Examples would be Altria (NYSE:MO), American Express (NYSE:AXP), AT&T (NYSE:T), CVS Health (NYSE:CVS), General Mills (NYSE:GIS), Goldman Sachs (NYSE:GS), Lockheed Martin (NYSE:LMT), McDonald's (NYSE:MCD), and Verizon (NYSE:VZ) (Most of the failures were on account of credit ratings).

I created charts for each of the qualifying point levels (20-19-18-17 or 16 points) to show how each company scored. In the charts, the following data fields are also provided, but they did not play a role in the scoring.

  • Years of increasing dividends. Note that companies with streaks less than 11 years did not increase their dividend during the Great Recession.
  • Simply Safe Dividends dividend safety score. I felt that this does not directly speak to long-term company quality, so I did not use it in determining company quality. That said, I do use it in deciding what investments to make.
  • Yield. High yield is not an indicator of company quality.

Here are the highest-quality dividend growth companies under this system.

Companies Scoring 20 Points

This select group of 11 companies got the highest score on every factor. This group includes the only two companies in the world with AAA credit ratings.

While the dividend safety scores were not part of the scoring, look at how high they are for every company in this group. Each company is a household name, for good reason. These are great companies. It is not often that you can find one of these companies at a bargain valuation. Everyone knows how good they are.

Companies Scoring 19 Points

These companies missed a perfect score on just one factor. Shaded cells show where each company fell short of the maximum score. Usually it was the credit rating.

*Two companies in this group have no S&P credit rating, but each has little or no debt. I decided not to penalize them for this circumstance (You might decide differently).

A few of these companies have lower dividend safety grades than we saw in the first group, and several of them also have short dividend increase streaks, which may give some investors pause. Some dividend growth investors require 20-25 years of increasing dividends to consider a stock for investment.

Companies Scoring 18 Points

These companies fell short on two factors, which are indicated by shaded cells. The two most common areas in which companies fell a little short are having a Narrow instead of a Wide moat, and credit ratings at the A level.

*These companies have no S&P credit rating, but they have little or no debt.

As in the group above, several of these companies have short dividend growth streaks that some investors might not accept.

Companies Scoring 17 Points

These companies fell short on three factors, shown by shaded cells.

*One company has no S&P credit rating, but it has little or no debt.

All of the companies in this group fell short of a top credit rating. Note Aon's (NYSE:AON) short dividend growth streak and low dividend safety score.

Companies Scoring 16 Points

These companies fell into the second-highest rating on all four rating factors. All the scoring cells are shaded.

# PH is noted in the CCC document as being overdue for an increase since January.

Interpreting the Data

Because of the stringency of the scoring system, all of these companies - even those in the final chart - would be considered "high quality" by most investors.

That said, perform further due diligence before investing in any of them. Quality is only one of many factors to consider, and there are many ways to measure quality besides the ones used here. Other areas to investigate include the whole dividend picture, whether the company fits with your portfolio and personal goals, and each stock's valuation.

Explanations of Rating Factors

Value Line Safety

Value Line is an independent subscription stock analytical service in business since 1931. The company has drawn kudos for the objectivity of its work.

Its Safety Rank is one of several proprietary ratings. This is how it explains its top two categories, which are the only two levels used in this article.

The Value Line Safety Rank measures the total risk of a stock relative to the approximately 1,700 other stocks [that Value Line covers]. It takes into account a stock's Price Stability rank and the Financial Strength rating of a company. Safety ranks are … given on a scale from 1 (Safest) to 5 (Riskiest) as follows:

Rank 1 (Highest): These stocks, as a group, are the safest, most stable, and least risky investments relative to the Value Line universe.

Rank 2 (Above Average): These stocks, as a group, are safer and less risky than most.

…Stocks with high Safety ranks are often associated with large, financially sound companies, many of which regularly pay cash dividends; these same companies also often have somewhat more moderate growth prospects because their primary markets tend to be mature.

Value Line Financial Strength

The Value Line Financial Strength grade is a proprietary rating. In this article, I only used the top two levels to help find the strongest stocks.

Value Line describes the Financial Strength rating as follows:

Value Line classifies 1,700 companies' Financial Strength ratings…from A++ to C, in nine steps…

Quite a few ingredients go into Value Line's Financial Strength ratings. 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 an important consideration….

Muddying the waters is the fact that not all industries are structured the same way financially. The Utilities and Financial sectors are prominent examples in that regard. Electric, natural gas, and water utilities are much more highly leveraged than industrial companies, with debt often topping 50% of total capitalization. Utilities are required to use more debt, because it is cheaper than equity. The increased financial risk is offset by reduced business risk, since utilities are a regulated monopoly…

For financial services providers, such as banks, thrifts, and insurance companies, the amount of capital, as measured by the equity to assets ratio, is a key consideration. More capital is better from a regulatory standpoint, but too much cuts down on profitability. Loss reserves are important, as well, as are funding sources. For lenders, deposits insured by the U.S. government represent a firmer source of liquidity than borrowings. It's when liquidity dries up that disruption occurs in the credit markets.

It's important to note that financial strength doesn't always translate into stock market outperformance…But, for investors looking for dividend-paying stocks and stocks to hold on to for a long period of time, it pays to be aware of a company's financial standing.

Morningstar Moat

Morningstar's Economic Moat rating is a proprietary data point from Morningstar, which is another independent analytical firm that has been in business since 1984.

Economic moats are like the moats around castles: They provide protection. Here is how Morningstar describes its process for assigning moats:

"Economic moat" is a term Warren Buffett uses to describe the sustainability of a company's future economic profits…We see the primary differentiating factor among firms as how long they can hold competitors at bay. Only firms with economic moats-something inherent in their business model that rivals cannot easily replicate-can stave off competitive forces for a prolonged period.

We assign one of three Economic Moat™ Ratings: none, narrow, or wide. There are two major requirements for firms to earn either a narrow or wide rating:

  • The prospect of earning above average returns on capital; and
  • some competitive edge that prevents these returns from quickly eroding.

In this article, I only used companies with a Wide or Narrow moat rating. A firm without an economic moat cannot be considered "high quality" for the purposes of this article.

S&P Credit Rating

Standard & Poor's bills itself as the world's foremost source of independent credit ratings. The company has existed as an independent financial analysis provider since 1941.

S&P credit ratings are forward-looking opinions about the creditworthiness of an obligor. The opinions reflect S&P's view of the obligor's capacity and willingness to meet its financial commitments as they come due, and may assess terms, such as collateral security and subordination, which could affect ultimate payment in the event of default.

Here are S&P's ratings categories:

In this article, I used the AAA-AA ratings (marked in red) as the top category and A (marked in aqua) as the second category. No other companies qualified. The sub-designations "+" and "-" were ignored.

Disclosure: I am/we are long KO, JNJ, MSFT, PG, AMGN, BA, CVX, CSCO, EMR, PEP, SBUX, AAPL, IBM, KMB, LOW, QCOM.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.