I’ve been reading more about Chowder’s Rule recently as I wanted to learn more about one of the columns in the US Dividend Champion list (it’s tucked away on the right hand side of the sheet in column BZ).
One of Chowder’s first rules in his stock screener is to find companies of “good quality”. But what does that mean?
What is Quality?
Back when I was at University studying Electronic Engineering, a friend of mine was studying Manufacturing. He used to talk about going to “Quality lectures” and I thought he simply meant any lecture where the professor did a good job presenting the course material. It took me some time until I finally realized that “Quality” was actually a subject all on its own! Yes, I can be pretty slow sometimes.
As it relates to Companies, the trouble with “Quality” is that it means many different things to many different people. In many ways Quality is in the eye of the beholder, and while its effects can be seen, it’s hard to measure.
Does the fact that a company increases dividends for 25 years mean that it’s a high quality company, and if so, what’s the magic number when the quality threshold is reached – 5, 10, 25 years? Is it cash flow, earnings growth, financial strength, profit margins, all of the above? Quality isn’t a simple value you can just plug into a stock screener in the search for quality.
Measuring dividend stock quality
For a quick initial yes/no litmus test on whether to investigate a stock further; Chowder’s approach and definition is simple:
“High Quality is defined as having superior financial strength. A company must have a 1 or 2 rating for Safety with Value Line, or a BBB+ rating or better with S&P. Both of these Financial Strength ratings indicate investment grade quality. … Anything that doesn’t meet the High Quality definition is considered speculation and managed differently within the portfolio.”
Companies have credit / investment ratings assigned to them, much as we have our own personal Credit Scores. Companies with low investment grades must pay higher expenses when borrowing money because they’re considered to have a higher risk of not paying their debt (aka defaulting) than highly graded companies. And you can imagine that there’s an army of people involved in researching and determining each company’s grade because of how much money is involved in that industry.
The S&P rating mentioned by Chowder is one agency; here’s a quick comparison of some credit ratings available on the web as well as the things I learned along the way.
S&P Investor Rating
You can obtain credit ratings for individual companies over at standardandpoors.com. You’ll be asked to create an account and supply email, password and name but it’s otherwise free and there are no charges. Their website is quite a pain to use because you have to pull each symbol individually however, and none of the screeners in my brokerage accounts allow this rating as a search criteria.
The S&P rating methodology grades companies from AAA (the highest), through AA, A, BBB, BB, B, CCC, CC and to R (in default). The symbols ‘+’ and ‘-‘ are used to denote positions with a rating e.g. AAA+ > AAA > AAA- > AA+.
Using Chowder’s definition, grades AAA+ through to BBB+ are investment grade companies and grades BBB through to CC- are speculative. Note that officially per the S&P rating, all BBB grades are investment quality not just BBB+.
I didn’t try to get the Value Line ratings. The sign up process looked more complicated than at S&P and they seem very interested in promoting their newsletters and stock selection methodology so I stayed away…
And went to Moodys instead which is a competitor to S&P. Their signup process is very similar to S&P’s (email, password and name) but I found their website better organized and it contained more information. It’s free to sign up and get basic ratings but there are charges for premium reports that detail the ratings and research on each individual company. I was still not able to find a list of stocks with a given credit rating, although their search tools are better than the S&P site.
Moodys’ rating methodology is more complicated than S&P’s with 25 different classifications. There’s the basic classification of Aaa (highest), then Aa, A, Baa, Ba, B, Caa, Ca and finally C (the lowest). Then within each rating (except for Aaa), there is an additional rating of 1, 2 or 3 showing the relative position within the rank. So Aaa > Aa1 > Aa2 > Aa3 > A1 > A2 > A3 > Baa1.
The grades of Aaa through to Baa3 are considered investment grade. Grades from Ba1 to Ca3 are speculative and C is in imminent danger of default.
Morningstar Credit Rating
Morningstar has their own credit rating score too. You can find it hidden on the “Bonds” tab of any individual stock quote page. Or you can view the entire list. This is a much easier system to work with than either S&P or Moodys, and is likewise freely available. One disadvantage here is that the coverage is not as high as with the previous two systems; I could not find scores for 6 companies that S&P and Moodys rated.
Morningstar’s scale is simpler though: AAA, AA, A, BBB, BB, B, CCC, CC and C. Any rating of BBB or higher is “Investment Grade” and ratings of BB through CC are considered more speculative grades. C is the rating that denotes imminent default on loan payments.
S&P Capital IQ Quality Rating
Finally I looked at S&P Capital IQ’s Quality Ranking score. S&P Capital IQ is related to the S&P Ratings service as they’re both owned by the same parent company – McGraw Hill. However Capital IQ is a more general investment data and analytics company competing with Bloomberg and Reuters.
The Capital IQ Quality Rating isn’t a standalone credit score; it rates growth and stability of earnings and dividends. This rating is not the same as the Capital IQ ‘star’ rating which is an aggregate of additional criteria. The Quality Ranking score is defined in a range from A+ (highest), A, A-, B+, B, B-, C+, C (lowest). Since it’s not a credit score, there’s not really a concept of Investment-Grade but the B+ score is considered “average”. So you could take either B+ or A- as a minimum threshold.
You can find the Quality Rating (and definition) on any S&P Capital IQ analysis report which are freely available via the Sharebuilder brokerage research tools and other brokerages. The Sharebuilder stock screener also includes this rating as a search criteria.
How do my stocks score?
I’ve normalized all the scores from the stocks in my portfolio to a common standard; using the Capital IQ scale as a baseline.
For Moodys, the conversion ignores the 1,2,3 classifier so I mapped Aaa=>A+, Aa*=>A, A*=>A-, Baa*=>B+, Ba*=>B, B*=>B-, etc.
For S&P, the conversion ignores the +/- classifier, e.g. AAA*=>A+, AA*=>A, A*=>A-, BBB*=>B+, BB*=>B and B*=>B- etc.
Finally for Morningstar, I used a similar scheme as the S&P conversion: AAA=>A+, AA=>A, A=>A-, BBB=>B+, BB=>B and B=>B- etc.
This yielded the following results for the stocks in my portfolio
The Moodys and S&P Ratings are not always available for a given stock symbol. Here’s a quick run through the stocks in the list above where I couldn’t initially find a rating. Another place to find the rating can be the company’s Annual Report.
Rockwood Holdings (ROC)
ROC’s debt is issued by one of its fully owned Subsidiaries, Rockwood Specialties Group. Using the conversions above, this rates a normalized B for Moodys, or B+ from S&P.
American States Water (AWR)
AWR’s debt is mostly dependent on its subsidiary, Golden State Water Company (GSWC). This rates a normalized A- for Moodys and an A- from S&P.
T. Rowe Price (TROW)
TROW aren’t rated by S&P or Moodys simply because they have no debt!
While the Capital IQ ratings are by far the easiest to query and are readily available for every stock I’ve searched for; I think I’ll pay more attention to Moodys credit rating going forward. I think it’s more focused than the Capital IQ rating and since it can directly affect the cost of borrowing of a company, it’s a meaningful rating. I’m pleased to see that most of the stocks in my portfolio have a good credit rating though!
Based on Moodys scores, my two lowest quality stocks are ROC and LB although the news is not all bad. ROC is currently under watch for a possible upgrade after the announcement of the pending sale to Abermarle. LB was upgraded one step in 2011 due to strong performance and debt repayment, putting it in the top tier of its grade and the company currently has a stable outlook.
Quote of the day
Quality means doing it right when no one is looking.