Dividend growth investors like to invest in companies with long dividend growth streaks. Such companies usually have strong business models and are shareholder-friendly. Often, the dividend increase streak is a point of pride for these companies. So there’s a strong likelihood that these companies will continue paying and increasing their dividends, even in challenging economic times such as recessions and pandemics. A strong likelihood—but not a guarantee—as we saw last year when Ross Stores (ROST) suspended its dividend shortly after becoming a Dividend Aristocrat.
As a dividend growth investor, I look for high-quality dividend growth stocks trading at reasonable valuations. For me, a dividend growth stock is a stock with increasing dividend payouts in each of the past five years. Dividend Radar tracks such stocks every week and publishes a comprehensive spreadsheet, downloadable for free, every Friday. But how do we assess the quality of dividend growth stocks and know when they’re trading at reasonable valuations?
This article presents my approach to finding high-quality dividend growth stocks and explains how I approach stock valuation. I also present the top-ranked dividend growth stocks in each of the GICS sectors. For each stock, I provide quality indicators, key metrics, and fair value estimates.
DVK Quality Snapshots provide an elegant and remarkably effective way to assess the quality of dividend stocks. Devised by David Van Knapp, the system assigns 0-5 points to each of five quality indicators, for a maximum quality score of 25 points:
- Value Line’s Safety Rank
- Value Line’s Financial Strength ratings
- Morningstar’s Economic Moat
- S&P Capital’s Credit Ratings
- Simply Safe Dividends’ Dividend Safety Scores
My rating system is simply a mapping of different quality score ranges. Ratings are Exceptional (25), Excellent (23-24), Fine (19-22), Decent (15-18), Poor (10-14), and Inferior (0-9).
To rank stocks, I sort them in descending order by quality scores and use the following tie-breaking metrics, in turn:
- Dividend Safety Scores
- S&P Credit Ratings
- Dividend Yield
When two stocks with the same quality score have the same Dividend Safety Score, I next compare their S&P Credit Ratings, ranking the one with the better Credit Rating higher. I rarely need to break ties with Dividend Yield.
A quick method to estimate the fair value of a dividend-paying stock is to divide its annualized dividend by its historical average dividend yield. This method works particularly well for stable businesses that pay ever-increasing dividends.
Of course, there are more sophisticated stock valuation methods, such as the Dividend Discount Model [DDM], which assumes a company’s fair value equals the present value of future dividends. In the past, I used an elaborate three-stage DDM but found that even minor adjustments to the inputs produced wildly varying results.
Now I prefer a survey approach, collecting fair value estimates and target prices from several reliable online sources. With as many as 11 available estimates, I ignore the lowest and highest, then average the mean and median of the remaining values to arrive at my fair value estimate. Averaging the mean (average) and median (middle value) helps adjust skewness in the surveyed estimates.
While I prefer to buy at discounted valuations, I’ve found that the highest-quality dividend growth stocks rarely trade at discounted valuations! For this reason, I'm willing to pay a bit of a premium price for such stocks.
Dividend growth investing is a long-term endeavor, so I think paying a small premium and getting into the game is better than waiting on the sidelines for an ideal entry point.
The Top-Ranked Stock in each GICS Sector
The Global Industry Classification Standard (GICS) is an industry taxonomy developed by MSCI and S&P Global Ratings for the global financial community. The GICS structure identifies 11 sectors into which all major public companies have been categorized.
I thought it would be interesting to identify the top-ranked stock in each GICS sector. So I analyzed all the stocks in Dividend Radar using DVK Quality Snapshots, ranked them by descending order in each of the 11 GICS sectors, and picked out the top-ranked stock:
And here are these stocks in overall rank order, with tickers of stocks I own in my DivGro portfolio, highlighted:
1. Johnson & Johnson (JNJ)
Founded in 1886 and based in New Brunswick, New Jersey, JNJ has grown into one of the largest companies in the world. The company is a leader in the pharmaceutical, medical devices, and consumer health industries. JNJ distributes its products to the general public, retail outlets, distributors, wholesalers, hospitals, and health care professionals.
2. Microsoft Corporation (MSFT)
Founded in 1975 and based in Redmond, Washington, MSFT is a technology company with worldwide operations. The company’s products include operating systems, cross-device productivity applications, server applications, productivity and business solutions applications, software development tools, video games, and online advertising. MSFT also designs, manufactures, and sells several hardware devices.
3. The Procter & Gamble Company (PG)
Founded by William Procter and James Gamble, PG is focused on providing branded consumer packaged goods in more than 180 countries. PG has five reportable segments: Beauty, Grooming, Health Care, Fabric & Home Care, and Baby, Feminine & Family Care. The company was incorporated in Ohio in 1905 and is headquartered in Cincinnati, Ohio.
4. NIKE, Inc. (NKE)
Founded in 1964 and headquartered in Beaverton, Oregon, NKE is engaged in the design, development, marketing, and selling of athletic footwear, apparel, equipment, and accessories. The company's portfolio brands include NIKE, Jordan, Hurley, and Converse. NKE sells its products to retail accounts, through NIKE-owned retail stores and websites, and independent distributors and licensees.
5. Honeywell International Inc. (HON)
HON is a diversified technology and manufacturing company with worldwide operations. The company provides aerospace products, software, and services; control, sensing, and security technologies; materials, process technologies, and automation solutions; and productivity, workplace safety, and asset performance solutions. HON was incorporated in 1985 and is headquartered in Charlotte, North Carolina.
6. BlackRock, Inc. (BLK)
BLK is an investment management company that provides a range of investment and risk management services to institutional and retail clients worldwide. The company’s offerings include single and multi-asset class portfolios investing in equities, fixed income, alternatives, and money market instruments. BLK was founded in 1988 and is based in New York City.
7. Ecolab Inc. (ECL)
Founded in 1923 and headquartered in St. Paul, Minnesota, ECL provides water, hygiene, and infection prevention solutions and services worldwide. ECL’s cleaning and sanitizing products, pest elimination services, and equipment maintenance and repair services support customers in various sectors, including food service, food and beverage processing, hospitality, healthcare, retail, textile care, and commercial facilities management.
8. Comcast (CMCSA)
Founded in 1963 and headquartered in Philadelphia, Pennsylvania, CMCSA is a global media and technology company. The company operates through Cable Communications, Cable Networks, Broadcast Television, Filmed Entertainment, Theme Parks, and Sky segments. CMCSA delivers broadband, wireless, and video connectivity; creates, distributes, and streams entertainment, sports, and news; and operates theme parks and resorts.
9. NextEra Energy, Inc. (NEE)
NEE generates, transmits, distributes, and sells electric power to retail and wholesale customers in North America. The company generates electricity through wind, solar, nuclear, and fossil fuel. It also develops, constructs, and operates assets focused on renewable energy generation. NEE was founded in 1984 and is based in Juno Beach, Florida.
10. American Tower Corporation (REIT) (AMT)
AMT is a real estate investment trust that owns, develops, and operates multi-tenant communications sites worldwide. Customers include wireless service providers, radio and television broadcast companies, wireless data and data providers, government agencies, and municipalities. AMT was founded in 1995 and is headquartered in Boston, Massachusetts.
11. Chevron Corporation (CVX)
Founded in 1984 and based in San Ramon, California, CVX is a multinational energy corporation involved in all aspects of the oil and gas industries, including exploration and production; refining, marketing and transport; chemicals manufacturing and sales; and power generation. CVX has operations in about 180 countries.
Key Metrics and Fair Value Estimates
Below, I present a table with key metrics of interest to dividend growth investors. These include the years of consecutive dividend increases (Yrs), the quality score according to DVK Quality Snapshots (Qual.), the forward dividend Yield for a recent Price, and the 5-year compound annual dividend growth rate (5-Yr DGR). Also included are the five quality indicators used by DVK Quality Snapshots.
I provide fair value estimates (Fair Val.) to help identify stocks that trade at favorable valuations and show the discount (Disc.) or premium (Prem.) of a recent Price to my fair value estimate. The last column shows each stock’s 5-year compound trailing total returns (5-Yr TTR).
Here's a comparative analysis of an equal-weighted portfolio of these stocks, courtesy of Finbox.com:
From a price-performance perspective, the portfolio would have outperformed the S&P 500 over the last five years. It is noteworthy that these stocks did not drop as much as the broader market in late February/early March 2020. This indicates that the group has a low beta, which is confirmed in the ranking table on the right.
Six of the 11 stocks have outperformed the S&P 500 on a total return basis over the past five years:
MSFT has done exceptionally well over the past five years, returning 36.2% annually!
CMCSA and CVX are the only discounted stocks.
Below is a yield channel chart of CMCSA, courtesy of Portfolio Insight. CMCSA’s stock price is in the channel, indicating that the stock is trading within the fair value range.
As for CVX, the yield history chart below confirms the stock is discounted. Whereas CVX currently yields 4.69%, the stock’s 5-year average yield is 4.40%. That means CVX is trading 7% above its 5-year average yield (or about 7% below fair value).
I’m also willing to consider buying JNJ and PG based on my quality/valuation criteria mentioned earlier.
Perhaps the best illustration of why I’m willing to buy high-quality stocks even above fair value is the following fair value chart of JNJ, calculated based on how the stock has been valued over a trailing ten-year period. The default metric used is Non-GAAP EPS. The charts show projections based on future earnings estimates. If those estimates materialize, JNJ should perform quite nicely.
The case is only somewhat less compelling for PG:
Should the stock price revert to the level represented by its median P/E of 19.24 (the blue dashed line), then an investment may not produce positive returns. But PG yields 2.57% and has a low Beta of 0.41, so I think the stock is worth considering.
In this article, I presented the top-ranked dividend growth stock in each of the GICS sectors. CMCSA and CVX are available at discounted valuations, but I think JNJ and PG are goods buys for investors willing to pay a small premium. I rate both JNJ and PG Excellent and will consider buying shares even up to a 10% premium above my fair value estimates.