While dividends have historically accounted for 20-40% of the stock market’s total return, dividend investors need to remember that changes in the stock’s price still account for the majority of returns. In our opinion, some of the biggest factors that can determine how much a stock moves are: (1) the industry it operates in; (2) the amount of operating leverage in its business model; (3) the amount of financial leverage on the balance sheet; (4) the size of the company; and (5) the current valuation multiple.
Many investors seeking sources of safe, current income focus almost exclusively on the current dividend yield, the payout ratio, and maybe the price-to-earnings ratio (“P/E”). And why not? After all, this is the easiest data to collect, and learning how to analyze an entire company and its full financial statements can be a complex, time-consuming task. With the typical annual report running more than 100 pages in length, knowing what information is important and what doesn’t matter to the stock’s story is hard to assess.
However, we believe there are some universal risks that should be assessed for any stock, whether it pays dividends or not. We think through each of the five risk factors mentioned above every time we analyze a stock. The good news is that assessing each risk factor for a stock doesn’t take too much time. The great news is that doing this simple homework can drastically help you avoid buying stocks at the wrong time or getting into a position that has far more downside risk than you were aware of. When it comes to preserving your nest egg, these are two huge benefits you can’t afford to miss.
With that said, let’s take a closer look at each of the five risk factors above and how we quickly assess each factor.
Risk Factor 1: The Industry
The health of a stock’s industry is as important, if not more important, than the performance of the individual stock itself. Even the best company in a weak industry will often underperform when its industry moves out of favor. Not surprisingly, some industry’s are a lot tougher to make a buck in than others.
Take steel producers, for example. Steel is largely a global market, meaning that many competitors can export their finished steel products to different parts of the world to compete. China is a major force in the steel industry, with many of its steel companies directly subsidized by its government. As such, they can offer significantly lower prices for their steel thanks to the government’s financial backing. For steel companies based in the US, this is a pricing nightmare. No matter how efficiently they run their factories, they are still selling a commodity and competing against an unlimited supply of companies with deeper pockets.
In general, commodity companies have much less in their control – the prices they receive for their goods are almost completely based on the industry’s supply and demand balance. Unless a player controls a dominant part of the market to manage the supply side of the equation, anything can happen. We are seeing this most recently in the oil market. In these industries, stocks are extremely correlated to each other depending on how the commodity cycle is playing out.
While oil, natural gas, steel, gold, cement, copper, corn, and wheat are some of the many obvious places to find commodity producers, it’s really the companies that sell to or somehow benefit from the health of the actual commodity producers that can cause the most surprises. For example, Deere’s stock steadily beat the market throughout most of the period from 2000 to 2010 as farmer income climbed to record levels, riding the tails of rising crop prices and generous government policies. However, farmer income peaked out a couple of years ago and has since declined. On the ride up, investors were quick to point out the factors that made Deere a great company but were less willing to acknowledge the role that rising farmer income was playing (i.e. more luck than skill). Sure enough, since farmer income peaked, Deere has been a very disappointing stock.
The takeaway is to really understand what drives demand for the majority of a company’s products? Are its customers or customers’ customers sensitive to the price of a particular commodity? If so, how strong has that commodity been, and what could change from a supply / demand standpoint?
Commodities can increase risk because the pace of change can be sudden and unexpected, completely wiping out earnings estimates. The oil industry comes to mind. In general, the slower the pace of industry change, the better for long-term dividend investors. While the technology industry is not necessarily the first thing that comes to mind when you think about commodities, it is notorious for its rapid pace of change. In reality, this is no different than industry supply or demand quickly expanding or contracting. As such, it is usually more difficult for technology companies to survive as long as firms in slower-moving industries. For this reason, also keep in mind how quickly demand or supply trends can change in an industry. What’s popular today could be a thing of the past in just a few short years.
Other industries are very different from commodities and technology and generally provide more favorable hunting grounds for long-term dividend investors. A company like Coca-Cola has historically demonstrated much greater control over its pricing. Rather than be subjected to the ebb and flow of global supply and demand for soda, Coca-Cola pushes through price increases on the strength of its brand and product taste. While soda demand is declining, the pace of decline is still very moderate given consumers’ addition to the taste, caffeine, and brand.
One way to identify slow-moving sectors ripe for long-lasting dividend growth stocks is to look at the sector mix of the dividend aristocrats stocks. To be a dividend aristocrat, the stock must be a member of the S&P 500 and have increased its dividend for at least the last 25 consecutive years. You can see all of the dividend aristocrats here, updated daily.
Not surprisingly, consumer staples leads the way, and technology is at the very bottom:
Risk Factor 2: Operating Leverage in the Business Model
Operating leverage can be a difficult concept to grasp if you have never heard of it before. Essentially, operating leverage is all about how quickly a company’s earnings fall or rise in response to a change in sales. Companies with a high proportion of variable costs will see a smaller move in earnings when sales move because variable costs move up or down more with sales. An example of this type of business would be an advertising agency since most of its costs are labor. If demand for projects drops, there is more flexibility to change its headcount to lessen the blow to profits.
Companies with a high proportion of fixed costs can see massive moves in earnings when demand strengthens or weakens for their products. Think of a cement manufacturer, for example. When cyclical construction markets drop, there is less need for cement. A cement manufacturer still needs to run most of its factory to meet the lower amount of demand for its cement, incurring a much higher amount of cost relative to production compared to when times were good and volumes were higher.
To assess a company’s operating leverage, it’s easiest to look at how the business performed during the financial crisis. How much did sales drop? Did earnings decline at a significantly faster rate than sales growth? What is the nature of the business – is it very capital-intensive or are costs more variable in nature? You can use our free recession performance analyzer tool to see how any dividend-paying stock did during the recession.
For example, Cummins (CMI) has a lot of operating leverage. Its sales fell 25% in fiscal year 2009, and its earnings plunged by more than 57%. See our full analysis of CMI here.
Source: Simply Safe Dividends
On the other end of the spectrum, Accenture (ACN) is a people-based consulting business. Its sales fell 8% in 2009, and its earnings only dropped 8%. Our full analysis of ACN is here.
Source: Simply Safe Dividends
Companies with high operating leverage will see the biggest drop in earnings during a demand pullback, generally resulting in much greater stock price volatility. You need to have a tough stomach to own many of these businesses throughout a cycle.
Risk Factor 3: Financial Leverage on the Balance Sheet
If you were to purchase an entire company, you would take on all of its outstanding debt. As such, the total value of a company is the sum of its total book debt (less any cash on hand) plus the market value of its stock. This number is called the company’s enterprise value.
So, if a company’s current market cap was $500 million and it had $500 million of debt and $100 million of cash, what would its enterprise value be? $900 million ($500 million market cap + $500 million debt – $100 million cash).
What causes a company’s enterprise value to change? Many things cause the price of a company to change, but most often change is driven by earnings volatility. If earnings drop or investors don’t think the company’s future cash flow will be as substantial as they previously did, enterprise value comes down.
If you look at the components of enterprise value (market cap, debt, cash), a company’s debt is fixed (they owe what they borrowed), and cash is usually a small component of the overall equation. Therefore, if expectations about a company’s worth decrease, almost all of the loss in enterprise value comes from the company’s market cap (i.e. the stock’s price drops).
Let’s take an example using a fictitious company called Coal Inc.
Market Cap: $300 million
Book Debt: $800 million
Cash: $100 million
Enterprise Value: $1 billion ($300 million market cap + $800 million debt – $100 million cash)
Now suppose coal prices dropped and the market believed the enterprise value of Coal Inc. was no longer $1 billion but only $800 million, a decrease of 20%.
With lower profitability, Coal Inc. wasn’t able to generate any additional cash or reduce its debt. The company still owes $800 million and only has $100 million of cash on hand. Knowing the new enterprise value and current debt level, we can solve for the impact on the company’s market cap.
$800 million enterprise value = $800 million debt – $100 million cash + Coal Inc.’s current market cap
$800 million enterprise value = $700 million net debt + Coal Inc.’s current market cap
To make the equation balance, Coal Inc.’s market cap would have fallen from $300 million to $100 million, a drop of 67%! Financial leverage magnifies the returns received by equity holders. Companies with more volatile business operations typically see greater swings in the market’s assessment of their current value. If these businesses have substantial debt loads, equity holders should be ready for some serious volatility. Certain business models, like telecom providers or utilities, have very low business volatility and high levels of capital intensity. Their debt is less of a concern because it is backed by secure assets and tied to predictable cash flow.
For most other types of businesses, we prefer to see a debt to capital ratio of no more than 50%, healthy free cash flow generation, and strong coverage ratios (e.g. net debt / EBIT of less than 5x). You can view all of these credit metrics in our Stock Analyzer tool.
Risk Factor 4: The Size of the Company
Small companies offer a very different risk return profile compared to mid and large cap companies. Most of these businesses have greater growth potential because of their smaller sales base. However, this also means some of these companies have much less diversified revenue streams, lower economies of scale, and potentially less operating experience than their larger peers. As such, the rate of failure is higher.
Mega cap companies have been in operations for a long time and generally have much more stable and diversified streams of cash flow coming in. Their economies of scale, distribution networks, and massive budgets for R&D and marketing keep them more insulated than small caps. For these reasons, they tend to exhibit less volatility than small caps and have more secure dividend payments.
If you are looking at a small cap company, be sure to understand how reliant its revenue is upon a single set of products, the pace of industry change, and the potential disadvantages caused by the company’s smaller scale and lower financial firepower.
Risk Factor 5: The Current Valuation Multiple
“Price is what you pay, value is what you get.” – Warren Buffett
Most investors have likely heard this quote before, but its meaning is timeless. Price and value are not always the same. Price is easy to understand – what amount is the stock currently valued at in the market? Intrinsic value is much more subjective because it is, in theory, the discounted value of all of the future cash flow a company will generate. If intrinsic value is significantly different that the stock’s value in the market today, there could be either a great buying or selling opportunity.
Calculating intrinsic value might sound easy, but it is extremely difficult in practice. What discount rate should you use to discount a company’s future cash flows? How long can a company continue growing sales at 5%? Can a business really maintain high profit margins, or will they eventually fade? When?
However, the intrinsic worth of a stock is much less volatile than the price the market offers you over time. As we all know, the market can be a very emotionally-charged place, even for bland dividend investing. For example, a stock with an intrinsic value of $100 could very easily see its stock price fluctuate between $50 and $250 over the course of a market cycle (i.e. its price falls 50% below its intrinsic value at the bottom and rises 150% above intrinsic value at the top).
The key is to let price volatility work in your favor and remember why you bought part of the business in the first place. Just because a stock’s price falls by 20% after your initial purchase doesn’t mean that your assessment of intrinsic value was wrong. Price will almost always be more volatile than intrinsic value. As long as nothing has changed to impact the long-term, normalized earnings of your investment, you shouldn’t have much to worry about.
However, given the major divergences that can occur between price and intrinsic value, you can get into a lot of trouble buying a stock that trades far above its intrinsic value, even if it is an excellent company. In these cases, you have no margin for error. If the slightest hiccup occurs and impacts near-term earnings, sentiment surrounding the stock could change and cause a large correction to push the price back closer to or even below intrinsic value. Ouch.
Each investor approaches valuation in their own way. That’s the beauty of free markets. We typically prefer to invest in higher quality businesses that earn solid returns on capital, maintain reasonable balance sheets, compete in slower-moving industries, have long operating histories, and appear to have continued opportunities for moderate growth. As long as we are right about the sustainability of the company’s returns and opportunities for growth, we feel good about buying these stocks for no more than about 20 times earnings. As Buffett also said, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” When it comes to dividend growth investing, we embrace this advice. So, if you are looking at a dividend growth stock trading for more than 20 times earnings, you really need to ask yourself if you are getting good value or should wait for a better pitch to come your way since price volatility far exceeds intrinsic worth variability.
Putting it altogether, it’s important for dividend investors to remember that changes in a stock’s price still account for the majority of the market’s return. While we believe just as much as you do that dividend-paying stocks are the best long-term investment vehicle, many of them carry much higher risk than typical stocks in the market. The stocks likely to have the most price volatility are those which compete in commodity-driven industries (directly or indirectly), have high amounts of operating leverage (i.e. high fixed costs), maintain substantial financial leverage, are smaller in size, and currently trade at excessive multiples relative to recent demand trends in their industry.