Sunday, February 3

Week 83 - Low-Risk Small- and Mid-Cap Dividend Achievers

Situation: “Opportunity risk” is a phrase used by investors to denote the last consideration they check off their list before parting with hard-earned money. Spending on any investment means there will be less money available to support an even better opportunity. “Opportunity risk” is a reminder to all of us not to avoid making the chancy investments that eventually produce growth. We define these chancy investments as small & mid-cap stocks, emerging market stocks & bonds, oil & gas exploration and production companies, pipeline companies, diversified engineering companies that support infrastructure development, and food producers that support the growing world population. There is also opportunity risk for governments when they shy away from expensive but rewarding infrastructure projects that are so essential for GDP growth, like 10 gigabit/sec internet connectivity for every home and office.

Smaller companies can grow rapidly but usually have more cash flow problems and less resilience than large companies, often taking on too much debt. But even without troublesome debt and cash flow problems their stocks are often volatile. This is because investors hop on the bandwagon expecting that growth to get even more exciting but it inevitably slows. These “momentum investors” then sell at a loss, even though growth remains impressive. Apple stock (AAPL) is a current example of how the bandwagon works, and shows that even the largest companies can fall prey.

Companies that offer a good and growing dividend can usually avoid large price swings, so we have consulted the buyupside list of 199 Dividend Achievers (companies that have raised dividends annually for 10+ yrs), excluding those in the S&P 500 Index. We also require that stocks on our list meet our definition of a hedge stock (see Week 82):
        a) a 15-yr annualized total return that beats the S&P 500 Index (VFINX);
        b) a Lehman Panic (10/07-4/09) total return that is less than 65% as bad as the 45.6% loss in the S&P 500 Index;
        c) a 5-yr Beta of less than 0.65.

Our survey has turned up 28 companies (see attached Table) but only 7 are free of red flags in metrics for efficiency (ROIC), debt (LT debt/total capitalization), and cash flow (FCF/div). Those 7 companies include two food producers (LANC & SAFM), two property & casualty insurers (HCC & WRB), one company that sells cleaning products (CHD), one that builds pipelines and collects tolls for oil & gas transportation (PAA), and one that provides conventional electricity (MGEE). Close study of the table will show that all 28 companies have remarkably strong and steady profitability. 

Bottom Line: These days economic growth is constrained, so investors need to carefully take on more risk to adequately prepare for retirement. The “new normal” is a term you’ve seen by now, used to describe globally weak economic growth (due to vast amounts of debt that have to be serviced or repaid). The “new normal” clearly sums up present reality. What is less clear is that the financiers who came up with the term also think it sums up future reality. Why? Because the underlying reasons are long-term: a) governments, companies and families have borrowed too much in the expectation that the heady growth of the 1990s will come back and pay off those loans. b) But GDP growth at those 90s rates is unlikely to return because commodity prices (for oil, iron, copper, corn, soybeans, etc.) are likely to grow faster than “core inflation” when over a hundred million people/yr are emerging from poverty and wanting a better life. 

Let’s take oil as an example. Think about the expense and risk of a) drilling in deep water, b) hydro-fracking for oil and gas that is locked in deeply buried shale deposits, c) bulldozing and boiling tar sands into bitumen, and d) drilling under the Arctic Ocean. Then remember that oil is the main up-front cost for running a modern economy. When energy is cheap, GDP growth is readily achieved: the growth rates for both GDP and the price of oil have been the same since 1960 at 3.1%/yr (adjusted for inflation). But oil was cheap for only the first half of that 52-yr stretch (its been tripling in price every 10 yrs for the last half). You can see the problem, and its not going to go away until cheaper and cleaner energy substitutes are developed. The only near-term solution is conservation (driven by heavy taxation of electricity, vehicles, and fuels), such as Denmark has been doing for decades.

Risk Rating: 6.

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