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Friday, September 2, 2022

DVK Quality Snapshots

David Van Knapp [DVK] presented a simple yet effective quality scoring system for dividend growth [DG] stocks in this article. I adopted the system in late 2019 as the primary way to assess the quality of DG stocks. 

The system employs five widely used quality indicators from independent sources and assigns 0-5 points to each quality indicator, for a maximum of 25 points. 

While there are other factors I consider when selecting stocks for possible investment, I love the simplicity of DVK Quality Snapshots. It does a remarkable job identifying high-quality stocks!

This article aims to summarize the quality scoring system and the modifications I've made to assess the quality of more than 700 DG stocks in Dividend Radar. I also present my ranking system, as I often write articles providing ranked lists of high-quality DG stocks. 

Quality Scoring

The quality scoring system developed by David Van Knapp (henceforth, the DVK Quality Scoring System) employs five quality indicators and assigns 0-5 points to each quality indicator, for a maximum of 25 points. Here are the quality indicators used in determining a stock's quality score: Readers can learn more about these quality indicators by following the provided links. 

VL's Safety Rank measures the total risk of a stock relative to approximately 1,700 other stocks covered by VL. The safety rank is computed by averaging two other value line indexes, the price stability index and the financial strength rating. Safety ranks range from 1 (highest) to 5 (lowest). Conservative investors should try to limit their purchases to equities ranked 1 (highest) and 2 (above average) for safety.

VL classifies the Financial Strength ratings of about 1,700 stocks in nine steps, from A++ to C. The lowest rating is reserved for companies in serious financial difficulty. In assigning ratings, VL considers much of the same information used by the major credit rating agencies, including net income, cash flow, amount of debt outstanding relative to equity, the outlook for profits, industry stability, and individual company returns.

The next quality indicator is M*'s Economic Moat, a proprietary data point that reflects a company's sustainable competitive advantage. A company with an economic moat can fend off competition and earn high returns on capital for many years to come. A wide-moat company is positioned to sustain economic profits for at least 20 years, whereas a narrow-moat company can do so for at least 10 years. A no-moat company has either no advantage or one that will quickly dissipate.

S&P's Credit Ratings are forward-looking opinions about the ability and willingness of debt issuers to meet their financial obligations on time and in full. Credit ratings address creditworthiness rather than investment merit. S&P uses a rating scale from AAA through D, with ratings from AAA through BBB- considered investment grade, and ratings from BB+ through D considered speculative grade. 

The final quality indicator from SSD is Dividend Safety Scores, which predict dividend risk over a full economic cycle by analyzing important dividend-related metrics, including payout ratios, debt levels, and coverage metrics, recession performance, dividend longevity, industry cyclicality, free cash flow generation, and forward-looking analyst estimates. Scores range from 0 to 100:

Source: Simply Safe Dividends

 Here is the scoring system used to compile Quality Snapshots:

    May 2021 Update: Dividend Safety Scores of 21-40 (Unsafe) now earn only 1 point, not 2.
    August 2022 Update: DG Stocks with Debt/Capital < 10% now earn 4 points, not 3.

Generally, 5 points are assigned to the highest ranks and best ratings, so the highest quality DG stocks would get 5 points on every indicator for a maximum score of 25. 

Some of the quality indicators do not map to every point in the scoring system. For example, M*'s economic moat rating distinguishes between wide, narrow, and no moats. The scoring system assigns 5 points for Wide moats, 4 points for Narrow moats, and 2 points for No moats. DVK does not penalize companies with No moats because "some companies can still succeed simply based on customer preferences."

For S&P credit ratings, points are only awarded for investment-grade stocks (AAA through BBB–). A stock gets either 5, 4, 3, or 0 points depending on its credit rating. If a stock doesn't have a credit rating, it gets no points unless its Dept/Capital < 10%, in which case it earns 4 points. Originally, the scoring system did not have this exception for no or low-debt stocks. 

Quality Ratings

As mentioned earlier, the maximum quality score is 25 points (5 points for each of the five indicators). 

I distinguish between the following ratings depending on the total quality score:

The meanings of the monikers I chose are as defined in the Macmillan Dictionary:
  • Exceptionalextremely good or impressive in a way that is unusual
  • Excellentextremely good
  • Fineof very good quality
  • Decentgood, or good enough
  • Poorused for saying that something is not as good as it should be
  • Inferior if something is inferior, its quality is not good

Stocks with quality scores in the range of 15-25 are Investment Grade stocks, while stocks with quality scores below 15 are Speculative Grade stocks

Ranking Stocks

I rank DG stocks by sorting them in descending order by quality score. To break ties, I consider the following factors in turn:
  • SSD Dividend Safety Scores
  • S&P Credit Ratings
  • Dividend Yield
For example, at the time of this writing, Johnson & Johnson (JNJ) and Microsoft (MSFT) both have perfect quality scores of 25. To break the tie, I consider their Dividend Safety Scores first. Both have Very Safe scores of 99. Moving to the next tie-breaker, Credit Ratings, I note that JNJ and MSFT both have AAA credit ratings. Therefore, the final tie-breaker, Dividend Yield, is needed. Here, JNJ wins out because its dividend yield is higher than MSFT's dividend yield.

Issues and Changes

When I first learned about Quality Snapshots, I immediately liked its simplicity and adopted it for managing my DivGro portfolio and for the articles I write on DG investing. 

DVK and I have corresponded on ways to improve Quality Snapshots. We've agreed on two changes to the original scoring system:
  1. Dividend Safety Scores of 21-40 (Unsafe) earn only 1 point (instead of 2).
  2. DG Stocks with no Credit Rating but with Debt/Capital < 10% earn 4 points (instead of 3).
The exception for no or low debt stocks lacking a credit rating followed from a desire not to severely penalize such stocks. DVK recently updated the points assigned for this exception from 3 to 4.

One unresolved issue with DVK Quality Snapshots is the outsized impact on a stock’s quality score if the stock is not covered by VL. Since VL contributes two quality indicators to the scoring system or up to 10 out of 25 points, a stock not covered by VL immediately forfeits 10 points and can only score a maximum of 15 points! 

Making matters worse is that the VL Safety Rank is actually an average of two other VL metrics, the Price Stability Index and the VL Financial Strength rating! In essence, the Price Stability Index accounts for 2.5 points (indirectly), and the VL Financial Strength accounts for 7.5 points (2.5 points indirectly and 5 points directly)! 

We've considered replacing the VL Safety Rank with a suitable quality indicator from another independent source. Doing so would address the abovementioned issues, namely having two quality indicators from the same source and having one quality indicator that partially depends on another. So far, we haven't found a suitable replacement. 

One idea would be to use a stock's dividend increase streak, as the case could be made that a long increase streak is an indirect indicator of company quality. 

However, some companies really play games with increases, giving small, token increases (sometimes fractions of a penny!) just so they can boast about their long dividend increase streaks. That doesn't really tell me much about the quality of the company and its dividends.

Furthermore, I like that the existing quality indicators come from independent sources and are an amalgamation or synthesis of other input data. In contrast, the dividend increase streak is a single data point and would stand out as being different. 

Finally, I'd want to see a replacement that covers most DG stocks and can be downloaded in bulk.

In April 2022, I changed how I calculate the quality scores of stocks without VL coverage. Specifically, if a stock is not covered by VL, I multiply its quality score by 23/15 (and ignore the decimal digits) to somewhat compensate for the lack of VL coverage. 

For example, one of my long-term holdings in DivGro is Main Street Capital Corporation (MAIN), a principal investment firm that provides long-term debt and equity capital to lower-middle-market companies and debt capital to middle-market companies. 

Since MAIN is not covered by VL, it scores only 11 points:
  • VL Safety Rank: NA
  • VL Financial Strength: NA
  • M* Economic Moat: Narrow
  • S&P Credit Rating: BBB-
  • SSD Dividend Safety: 62
Prior to my change, MAIN would've scored 0 + 0 + 4 + 3 + 4 = 11 points, making it a Speculative Grade stock with a Poor rating. After the change, MAIN scores 16 points, making it an Investment Grade stock with a Decent rating:
  • 11×23÷15 = 16.867 (so MAIN scores 16 after ignoring the decimal digits)

In effect, stocks without VL scores are not penalized as much as before, but they do get penalized a little because I’m still limiting their maximum possible score to 23 points. 

I consider this change a stopgap measure until we find a suitable replacement for VL's Safety Rank

Concluding Remarks

In late 2019, I adopted DVK Quality Snapshots as the primary way to assess the quality of DG stocks. Despite some issues, the system does a remarkable job identifying high-quality DG stocks! 

In time, I'd like to replace VL's Safety Rank with a suitable quality indicator from another independent source. The replacement indicator should represent an aspect of quality not already covered by the other indicators. Additionally, I'd prefer to use an indicator (rank, rating, grade, or score) compiled or synthesized from several underlying data points and one that covers most DG stocks. 

If you have any suggestions about a possible replacement quality indicator, please let me know in the Comments below!

Thanks for reading, and happy investing!
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