Four kinds of risk and a tale of two stocks
Is the stock market more attractive now, or more risky, asks this Canadian advisory. It outlines the risk and illustrates with two stocks.
Do you remember when the stock market was trying to hold its ground at 8,000?
It was in the dead of winter and not much was growing, in nature or in the market.
But now the S&P/TSX Composite Index is back above 10,000 and brighter days are here … sort of.
A more expensive stock market can also be a riskier stock market, says The Investment Reporter. This venerable Canadian advisory has some advice on just how to treat this revived market.
Will it go higher, or has it hit a ceiling? And what should investors be doing — running out and buying or standing by until further notice?
Well you needn’t go on a buying spree, but there’s no need to stay out of the picture altogether. Just buy gradually and conservatively.
The advisory details the risks that exist in the market today, and illustrates with two stocks, one a buy and one a hold.
Interestingly enough, it’s the smaller of the two stocks that’s a buy and the bigger one that carries the greater risk.
Weighing down the market
The way this advisory sees it, there are four risks facing investors in the stock market today. The first is simply the quantity of shares out there.
Many companies have reversed the policy of buying back their own shares. Once a very popular initiative, it can no longer be counted on to help push share prices up.
But there’s more. It is likely that a number of firms will be taking advantage of the market’s rise to issue new shares. This, of course, has the opposite effect to a buyback — it can weight down the market.
Second, there’s less leverage. When times are good, it’s easier for investors to borrow and buy on margin. “They profited from prices rising faster than their interest payment,” says the advisory. In addition, many claimed tax deductions on that interest (so-called “carrying costs”).
With many more people paying down debt, a lot of that money has been removed from the market.
The question of pensions
The third risk is a more conventional one. In addition to the bankruptcies we’ve all heard about, many companies have seen their profits fall.
And company profits “play a critical role in setting share prices,” says the advisory. “Declining company profits and dividends should exert downward pressure on the market.”
Finally, there is the vexed question of pensions. Pension plans were at the heart of the matter as the big automakers and their unions struggled to come to agreement. But they’re not the only ones.
In happier days, the share prices of pension funds were rising so fast that some companies didn’t even have to make cash contributions. That all changed with the market meltdown, of course. The value of pension plans fell. The fall in interest rates didn’t help, either.
Now companies with defined benefit plans have to pour in more cash to cover their obligations. That cuts into profits and “re-directs cash from shareholders to pensioners,” points out the advisory.
There are other risks out there of course, such as political shocks. But these four risks alone should breed a certain caution. None of these risks will vanish overnight.
“You can cut your risk by buying gradually and sticking to high-quality, dividend-paying stocks,” says The Investment Reporter. “Dividend income lets you buy in market setbacks.”
Railway ties vs. auto parts
But those companies don’t all have to be familiar large-cap names. Stella-Jones (TSX-SJ), maker of railroad ties, telephone poles and other pressure-treated wood products, is a good buy among somewhat smaller fry, says this advisory.
Stella-Jones was a very hot stock in 2007, outpacing the raging bull market right up to the breaking of the subprime crisis. Subsequently, it slid back down with the rest of the market. Now it’s back.
The company just turned in a strong first quarter. Earnings per share jumped by 42 per cent over the year before, thanks in part to the added revenues from a big U.S. acquisition last year.
The rest of the year looks good as well. And so does next year. Railway ties make up 55 per cent of the firm’s business and railways are carrying more and more international trade.
The company will also benefit from government infrastructure spending as its pressure-treated wood goes into bridges, construction timbers and highway guardrail posts.
Stella pays a dividend of $0.36 and trades at an attractive price/earnings ratio of 9.4. The stock has been moving back up, but it remains an undervalued buy for this advisory.
A more famous stock, however, is not a buy. Magna International (TSX-MG.A) certainly has more headlines to its credit than Stella-Jones, especially after its successful coup with GM’s Opel unit in Germany.
The good side of the deal is that Magna will operate a company that sold 1,458,290 vehicles in Europe last year.
The risky side is that Magna is doing something it said it would never do — competing with its own customers.
“Would these customers retaliate by dealing with other autoparts suppliers?” asks The Investment Reporter. “Would these customers worry about Magna copying leading technologies?”
Until these questions are answered, Magna is a hold.
Know the risks, proceed step by step, buy carefully and gradually, and make sure you’re getting dividend payments along the way. This advisory believes that’s a pretty good approach to investing in any market.
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