Sunday, December 25

Week 25 - Master List Risk

Situation: Risk is headline news again!! Consumers and corporations alike are taking on less risk these days but governments are still struggling. This is because governments are singularly able to increase spending during a recession. The central banks of the US and China spent heavily in early months of the recent recession and are now able to switch gears and think about repairing their lopsided balance sheets. European central banks, on the other hand, aren’t as dynamic and those economies now face a drawn-out recession. US corporations have cut borrowing (the S&P 500 Index Debt/Equity ratio has fallen from 1.6 to 1.2 over the past 3 yrs). US consumers have trimmed household debt and are still avoiding taking on new risks like real estate or stock purchases.

Put simply, our key question for this week’s blog is: How should the ITR investor measure the risk of investing in stocks? And a follow-on question:  When is it smart to purchase a risky stock that has tumbled in value? Let’s dispense with the second question first. “Big money” is made in two ways, one of which is legal (taking on risk) and the second illegal (making trading decisions based on inside information). One of the effects of risk is to magnify volatility so that the stock will outperform in a rising market; but the downside amounts to a “near death experience” in a falling market. Experienced traders don’t consider buying stock in a “fallen angel” until after it has recovered ~40% of its lost value, and such a recovery can sometimes take years. The ITR DRIP investor isn’t going to want to be caught holding one of those stocks on the eve of retirement.

Now to address the first question: how is risk measured? In evaluating a company, “risk” is about volatility, debt, and cash flow that might not be enough pay a dividend. Price volatility can be assessed from the interactive graph function at Yahoo Finance by picking a stock index and charting it’s Bollinger Bands (BB) over the most recent two year (499 day) time span, setting the standard deviation at 4. To have a BB reference index that weights utilities and transportation companies better than the S&P 500 Index, we like to use the Dow Jones Composite Index (DJA) as our reference index for volatility. The Dow Jones Utility Index is a good metric for the performance of companies that provide essential goods, and the Dow Jones Transportation Index reflects “the pulse of the economy” better than the S&P 500 Index. The Dow Jones Composite Index will outperform the S&P 500 Index over extended periods of time. Why? Because it over-weights “boring transports and utilities.”

For the remaining two risk metrics (debt and cash flow), we use accounting data that can be found at both Yahoo Finance and the online Wall Street Journal ( Long-term (LT) debt that is more than 1/3rd of total capitalization is a red flag. Free cash flow (FCF) is our most important risk metric because it’s the source of dividend growth: FCF is red-flagged when it’s less than two times the current dividend payout. How is FCF measured? By going to the Statement of Cash Flows. Start with “net cash flow from operations”, i.e., the bottom line of the first part of a Cash Flow Statement. Then subtract from that number the first item (capital expenditures) of the second part - called “cash flow from investments”. Divide that number by the first item (dividends paid to holders of common stock) of the third part, which is called “cash flows from financing.” An FCF/div greater than 2 indicates that the company can comfortably pay its usual dividend and consider raising its dividend. Wikipedia gives two examples under the topic of “cash flow statement”; the second example (XYZ co. LTD) can be used to follow the guidance above. This company is unlike those on our Master List, in that it has negative cash flow from operations and yet pays a large dividend. FCF/div = -0.65. The accompanying table shows the 4 numbers from the Cash Flow Statement that are used to determine FCF/div for each company.

In the accompanying table <click here>, we provide risk metrics (2yr BB volatility score, LT debt/cap, and FCF/div from the most recent annual report) for each stock in the ITR Revised Master List (Week 16). We also note the current dividend and the average rate of dividend growth over the past 10 years. Our risk analysis shows that 10 of these companies are well-managed from the standpoint of risk: JNJ, ABT, BDX, WAG, MKC, ADP, XOM, MMM, GD, and TROW.

Bottom Line: Know what you’re buying. Rather than attempting to hit the ball out of the park by picking stocks poised to reap windfall profits from a bull market, a sounder approach is to get on base with a walk or single. Leave the home run attempts to the gamblers while you carefully build your retirement portfolio using sound, well thought-out decisions.

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