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.
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, 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.
Risk Factor 1: The Industry
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, Chinese steel producers can typically offer significantly lower prices for their steel thanks to the government’s financial backing. For steel companies based in the U.S., this is a pricing nightmare. No matter how efficiently they run their factories, and tariffs not withstanding, they are still selling a commodity and competing against an unlimited supply of companies with deeper pockets.
Unless a player controls a dominant part of the market to manage the supply side of the equation, anything can happen. In recent years we have seen this play out in the oil market as U.S. shale producers flooded the market with supply. 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 shortly later 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, once farmer income peaked, Deere turned into a disappointing stock, at least over the short term.
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 for 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, providing more favorable hunting grounds for long-term dividend investors. A company like Coca-Cola has historically demonstrated much greater control over its pricing, for example.
Rather than be subjected to the ebb and flow of global supply and demand for soda, Coca-Cola historically pushed through price increases on the strength of its brand and product taste. While soda demand is declining today, the pace of decline is moderate given consumers’ addition to the taste, caffeine, and brand.
Risk Factor 2: Operating Leverage in the Business Model
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.
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?
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 40%.
Risk Factor 3: Financial Leverage on the Balance Sheet
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).
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, utilities and REITs, have low business volatility and high levels of capital intensity. Their debt is usually less of a concern because it is backed by secure assets and tied to predictable cash flow.
Risk Factor 4: The Size of the Company
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 usually been in business 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.
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.
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.
Closing Thoughts on Finding Safer Dividend Stocks
While we believe just as much as you do that dividend-paying stocks are one of the best long-term investment vehicles, many of them can still 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.
Remaining aware of these core risk factors when selecting investments in your portfolio can help you stay focused on stocks that are best aligned with your risk tolerance.