Dividend stock quality – making sense of credit ratings

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+.

Value Line

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…

Moodys

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

Symbol Moodys S&P MorningStar Capital IQ
MSFT A+ A+ A+ A-
PFE A- A B+
T A- A- A- B+
ROC B B+ B
XOM A+ A+ A+ A
HD A- A- A- A
JNJ A+ A+ A+ A+
AXP A- B+ A- B+
PG A A A A+
UPS A A- A- B
CVX A A A A
MCD A- A- A A
JPM A- A- B+
KO A A A A+
INTC A- A- A B+
DOW B+ B+ B+ B-
AWR A- A- B
ADP A A A
UNP A- A- A- A+
KMB A- A- A- A
GXP B+ B+ B+ B
APD A- A- A- A
LNT A- A- B+
GIS A- B+ A- A
MAR B+ B+ B+ B+
RTN A- A- A- A+
TROW A-
LB B B+ B+
CB A A A- A
BMS B+ B+ B+
EMR A- A- A- A+
LMT B+ A- A- A+

Missing results

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!

Summary

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.

0 thoughts on “Dividend stock quality – making sense of credit ratings”

  1. Great post, DL. And timely too. I have been thinking about this and a couple of weeks ago was hunting for resources where it would give me credit ratings from different rating agencies together for a stock. Obv I couldnt find any. And like you’ve mentioned the signup process is a pain and I did not feel like doing it at a time – if it were one site, I wouldnt mind it, but between the 3-4 crediting entities and each having its own signup process – AND to top it off, a different scale seemed like too much work.
    I know, some hard work shouldnt stop me from doing my research on my investments, but c’est la vie.

    Coming back to point, thanks for putting this together – I have been intrigued since I read somewhere that only a handful of companies have the best AAA or the equivalent rating and MSFT, XOM, JNJ were amongst that list. I think this is one of the reasons why companies like JNJ, KO etc are always trading at a bit of a premium.

    Thanks for the writeup.
    R2R

      1. Hi R2R,

        Thanks for the link! That’s an interesting article and of the 4 listed there in 2011 (XOM, ADP, JNJ and MSFT), ADP has since dropped a rank and is now AA rated by S&P.

        XOM, MSFT and JNJ still hold the top S&P rating of AAA however, as well as the top Moodys rank. The way I converted the mapping in the results above means that A+ is only earned by the top possible rating.

        However, it’s not easy to tell from either website if there are other companies with the top rank. I tried to do a quick search on the S&P historical data and couldn’t find any others – even AAPL is still a AA+ rating.

        If you do happen to come across another source of credit data please let me know! 🙂

        Best wishes,
        -DL

    1. Hi R2R,

      I’m glad you found the post useful!

      I’m with you on the hard-work aspect of it all; it was quite painful getting the data and I couldn’t find a way of listing all companies with a specific credit rating which was a shame. Morningstar allows it via their entire list link and the Capital IQ scores can be screened at my brokerage but their ratings aren’t true scores.

      I suppose on the plus side, the ratings don’t change that often and it’s fairly easy to search the Moodys site especially looking for upgrade or downgrades.

      The other effect of a lower credit rating is that mutual funds may be forced to sell a stock when it falls below a certain rating or vice versa which can push the price down or up respectively. I wonder too if there are rules about how many top rated companies there can be at a time; if all companies had the top score the system wouldn’t work very well 🙂

      Thanks for your comments!

      Best wishes,
      -DL

    1. Hi DFG,

      There are general heuristics of ratio values that represent good financial health and it might be worth exploring any correlation to credit rating in a future post, but I’ve not come across anything specific to credit rating so far. I wasn’t especially looking for that though as I was initially trying to be lazy and let a bunch of analysts do all the leg-work.

      One thing I like about the S&P / Moodys numbers are that they directly influence the loans available to the company, unlike ratios and other ratings such as Morningstar. They do tend to be more current than balance sheet data too since even an announced dividend increase can trigger a credit rating review.

      Best wishes,
      -DL

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