Refining Risk Measurement Of Dividend Stocks

Posted by D4L | Tuesday, December 30, 2008 | | 3 comments »

Earlier we looked at the RQ (Risk/Quality) ratings of individual stocks. This was a good start to help us understand the risk profile of a stock, and our dividend stock portfolio, but it didn't quite go far enough. Since then I have continued to measure, calculate and calibrate a more comprehensive measure of risk. I sill use the RQ rating as 50% of the new measure, but I have added these two important indicators of risk:

I. Current Price vs. Calculated Price (P)
As part of my quantitative analysis, I calculate a "Buy Below" price. In short, this price is the lower of 1.) the Mid-2 Fair Value or 2.) price needed to generate an acceptable NPV MMA Differential. If the current price is less than plus or minus 10% of the calculated price then this portion of the calculation is assigned a value of 1 (low risk). A difference between plus or minus 10% but less than 20% is assigned a value 2 (medium risk), while anything plus or minus 20% or greater is assigned a 3 (high risk). The 10% and 20% are purely arbitrary and subject to future calibration.

This portion of the calculation determines if the stock is trading within an expected range based on historical metrics such as P/E and yield. Also considered are its valuations using a Graham number and a discounted cash flow model (DCF).

II. Dividend Yield (Y)
Dividend yield is an indication of market sediment, and often an early warning for a troubled stock. In this portion of the calculation, the current yield is compared to predetermined levels and a risk value is assigned. Currently, I am assigning a 1 (low risk) to yields less than 5%, a 2 (medium risk) to values from 5% to less than 8% and a 3 (high risk) for values 8% and greater. As above, the predetermined levels are purely arbitrary and subject to future calibration.

Some might argue that it is "normal" for certain industries to pay out a higher yield, such as 10%. However, I think that "normal" higher yield could be indicative of the implicit higher risk of that industry. Blue water shipping (ocean going) would be an example of this. Also, certain industries, such as utilities, tend to sustain a higher yield due to their lack of growth opportunities.

RQ Revisted
As noted in Measuring Dividend Stocks Investment Risk Profile, the RQ portion is calculated based on S&P's Qualitative Risk Assessment (R) and Quality Ranking (Q).

If the Qualitative Risk Assessment is A, 1 (low risk) is assigned; if B, 2 (medium risk) is assigned and if C, 3 (high risk) is assigned. For the Quality Ranking, S&P assigns ratings of A+, A, A-, B+, B, B-, C, D and Not Ranked. For this calculation, 1 (low risk) is assigned if the rating is A+, 2 (medium risk) is assigned if the rating is A or A-, everything else is assigned a 3 (high risk). Again, the predetermined levels are purely arbitrary and subject to future calibration.

Putting It All Together
My Risk Rating is calculated by averaging the four numeric values above, as such:

(R + Q +P +Y)/4 = Risk Rating

This calculation will yield values between 1 and 3. I divided this range into thirds and assigned an overall rating based on this table:

  • 1.00 to less than 1.67 = Low Risk
  • 1.67 to less than 2.34 = Medium Risk
  • 2.34 to 3.00 = High Risk
Snapshot Of My Dividend Stock Holdings
Currently, I am holding 35 dividend stocks (excluding ETFs and CEFs). Of which three are rated as high risk:

CenturyTel Inc. (CTL)
CenturyTel Inc. provides a range of telephone services in 25 states, with operations concentrated in Alabama, Arkansas, Louisiana, Missouri and Wisconsin.
Using the above formula (R + Q +P +Y)/4 = Risk Rating: (2 + 2 + 3 + 3)/4 = 2.50

Pfizer Inc. (PFE)
Pfizer, Inc. engages in the discovery, development, manufacture, and marketing of prescription medicines for humans and animals in the United States, Europe, Canada, Asia, and Latin America.
Using the above formula (R + Q +P +Y)/4 = Risk Rating: (2 + 3 + 3 + 2)/4 = 2.50

Health Care Property Investors Inc. (HCP)
Health Care Property Investors, Inc. operates as a real estate investment trust in the United States. The company, through its subsidiaries and joint ventures, invests in health care-related properties and provides mortgage financing on health care facilities.
Using the above formula (R + Q +P +Y)/4 = Risk Rating: (2 + 3 + 3 + 2)/4 = 2.50

17 of my dividend stock holdings are rated as medium risk. Some familiar stocks include:

Intel Corporation (INTC)
Intel Corporation engages in the manufacture and sale of semiconductor chips, as well as in the development of advanced integrated digital technology platforms for the computing and communications industries worldwide.
Using the above formula (R + Q +P +Y)/4 = Risk Rating: (2 + 3 + 3 + 1)/4 = 2.25

Eli Lilly and Co. (LLY)
Eli Lilly and Company discovers, develops, manufactures and sells prescription drugs that offers a wide range of treatments for neurological disorders, diabetes, cancer, and other conditions. The company also sells animal health products.
Using the above formula (R + Q +P +Y)/4 = Risk Rating: (2 + 3 + 2 + 2)/4 = 2.25

Nucor Corp. (NUE)
Nucor Corporation is engaged in the manufacture and sale of steel and steel products. As the largest minimill steelmaker in the U.S., Nucor has one of the most diverse product lines of any steelmaker in the Americas.
Using the above formula (R + Q +P +Y)/4 = Risk Rating: (1 + 3 + 3 + 1)/4 = 2.00

McDonald's Corp. (MCD)
McDonald's Corporation primarily franchises and operates McDonald's restaurants in the food service industry. These restaurants serve a varied, yet limited, value-priced menu in more than 100 countries around the world.
Using the above formula (R + Q +P +Y)/4 = Risk Rating: (2 + 2 + 3 + 1)/4 = 2.00

Consolidated Edison, Inc. (ED)
Consolidated Edison, Inc., through its subsidiaries, provides electric, gas, and steam utility services in the United States serving parts of New York, New Jersey and Pennsylvania.
Using the above formula (R + Q +P +Y)/4 = Risk Rating: (1 + 3 + 1 + 2)/4 = 1.75

I am holding 15 dividend stocks in the low risk category. Included in this group are:

PepsiCo, Inc. (PEP)
PepsiCo, Inc. (PepsiCo) is a global snack and beverage company. The Company manufactures, markets and sells a range of salty, convenient, sweet and grain-based snacks, carbonated and non-carbonated beverages and foods.
Using the above formula (R + Q +P +Y)/4 = Risk Rating: (1 + 1 + 3 + 1)/4 = 1.50

Wal-Mart Stores, Inc. (WMT)
Wal-Mart Stores, Inc. operates retail stores in various formats worldwide. It operates through three segments: Wal-Mart Stores, Sam's Club, and International.
Using the above formula (R + Q +P +Y)/4 = Risk Rating: (1 + 1 + 2 + 1)/4 = 1.25

Kimberly-Clark Corporation (KMB)
This global consumer products company produces tissue, personal care and health care. Its brands include Huggies, Pull-Ups, Kotex, Depend, Kleenex, Scott and Kimberly-Clark.
Using the above formula (R + Q +P +Y)/4 = Risk Rating: (1 + 2 + 1 +1)/4 = 1.25

The Coca-Cola Company (KO)

The Coca-Cola Company engages in the manufacture, distribution, and marketing of nonalcoholic beverage concentrates and syrups worldwide.
Using the above formula (R + Q +P +Y)/4 = Risk Rating: (1 + 2 + 1 + 1)/4 = 1.25

Johnson & Johnson (JNJ)

Johnson & Johnson engages in the manufacture and sale of various products in the health care field worldwide.
Using the above formula (R + Q +P +Y)/4 = Risk Rating: (1 + 1 + 2 + 1)/4 = 1.25

Three dividend stocks had a perfect score of 1.00 (low risk). They were:

United Technologies Corp (UTX)
United Technologies Corp. is an aerospace-industrial conglomerate with a portfolio including Pratt & Whitney jet engines, Sikorsky helicopters, Otis elevators and Carrier air conditioners, among other products.
Using the above formula (R + Q +P +Y)/4 = Risk Rating: (1 + 1 + 1 + 1)/4 = 1.00

Sysco Corp (SYY)
SYSCO Corporation, through its subsidiaries, engages in the marketing and distribution of a range of food and related products primarily for foodservice industry in the United States and Canada.
Using the above formula (R + Q +P +Y)/4 = Risk Rating: (1 + 1 + 1 + 1)/4 = 1.00

Procter & Gamble Co. (PG)
The Procter & Gamble Company (P&G) is focused on providing branded consumer goods products. The Company markets its products in more than 180 countries.
Using the above formula (R + Q +P +Y)/4 = Risk Rating: (1 + 1 + 1 + 1)/4 = 1.00

Overall, the weighted average (based on annual income) of my dividend stocks is 2.26, which would put it on the higher end of the medium category. In an effort to build up a risk reserve that can be accessed when a company cuts its dividend, I would like to lower this number to around 2.

I am still refining and calibrating the calculations. However, this is a good start in helping me manage and control the risk associated with my dividend stock portfolio.

Full Disclosure: Long CTL, PFE, HCP, INTC, LLY, NUE, MCD, ED, PEP, WMT, KMB, KO, JNJ, UTX, SYY, PG


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3 comments

  1. Dividend Tree // December 30, 2008 at 11:53 AM

    Another piece of gem from D4L data mining! 2008 showed the need for appropriate risk metrics.

    I have been playing around with different elements to calculate a risk number. Assigning individual risk number is exactly same as yours 1 (low), 2(medium), and 3 (high). But the parameters are somewhat different.

    Price (P) and Yield (Y) are similar to yours. However, I am not using RQ values. Instead I am modeling it as follows:
    [P + Y + Payout Ratio + Ratio of ShortDebt/FCF + Ratio of LongDebt/FCF] / 5.

    I am still calibrating the risk numbers for debt/FCF ratios. Should it be calibrated based on point in time or based on y-o-y rate of change? Still toying with it.

    Some food for thought!

  2. Joe // December 30, 2008 at 2:41 PM

    There is a very conservative options strategy called a "collar strategy" where you hold a stock (or an index) and sell covered calls against it, and use the money from the calls to buy "insurance" using puts. I’ve been doing a lot of research into using this strategy. It looks like a very good conservative strategy. While you can "roll this yourself", it’s a lot of work. I have found 2 ways to have somebody else implement this for me. One is a service: http://www.swaninvesting.com/ and requires a large investment ($400K), and the other is a closed-end fund (traded on the NYSE): Eaton Vance Risk Managed Diversified (symbol: ETJ). Currently ETJ pays almost 10% dividends, which can be reinvested, but because it is a closed-end fund, it can trade either below, at, or above it’s Net Asset Value.

    I'm wondering how ETJ calculates out in your formula?

  3. Dividends4Life // December 30, 2008 at 4:27 PM

    Dividend Tree: I like the idea of incorporating a debt load into the risk calculation. I look at debt but have not directly built it into my analysis.

    Joe: I have not heard of ETJ before. As time allows, I would like to take a look at it. Thanks for ringing it to my attention.

    Best Wishes,
    D4L

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