Reward and its Ugly Stepsister Risk

Remembering that I promised never to talk about politics in my articles, I will not mention the disturbing development this past week that the U.S. Government has now decided to sue the large U.S. money-center banks with two separate agencies and two separate lawsuits. Are these the same politicians who are wondering why U.S. banks are not lending and why U.S. consumers are too petrified to borrow, even those with good, stable employment? Economics has never been a strong subject for American politicians, maybe because it involves so much math, but surely someone, somewhere in the U.S. Government regulatory agencies can follow this (I'll even type slowly): If banks were reluctant to lend to consumers and business two weeks ago, they will be even more loath to lend now that, after regulators have forced them to increase their capital reserves to ridiculously high levels during the past three years, they will have to replace that capital after what can only be a sham of a trial, or more likely an expensive shotgun settlement. Oh, the Europeans have always been better at economics (and math) than we are.

Because of policy mistakes in the U.S., we now are facing the increased probability of a recession. What should we do? If you have a steady stream of investable savings, you should, as the stock market makes new lows, keep adding to positions of large multinational companies with good, stable dividends, like General Electric (GE) and Pfizer (PFE). Therefore, when the U.S. finally comes out of its slow-to-no-growth slump, the shares in your (nearly) permanent portfolio will swell with a healthy, wealthy glow. This is when your risk-tolerance is tested as an investor, and even if you never buy bonds, risk in finance is defined in terms of U.S. Government bonds.

A bond price and its yield are inversely related, that is, when the price of the bond decreases, it's yield, or its payout as a percentage as the bond price, increases. So, when bonds get cheap in value, their yields rise, and that's one way to determine how risky a bond is as an investment. You simply look at its yield compared to Treasuries, bonds issued by the U.S. government, and if the bond is trading at 5 percentage points above the Treasury yield, then it has a credit spread, sometimes called a risk premium, of 5%. A bond trading with a risk premium of 5% would be a very risky bond in the eyes of the market. In other words, the bond market, with such a high risk premium, is betting that the bond may not be able to pay its promised interest to investors and, therefore, might default.  

We also can apply the concept of risk premium to stocks and their dividends, more or less. Let's say that a stock, based on its current price, boasts a 7% annual dividend yield. The market is betting that in the future the company will not be able to pay the dividend that it currently offers; otherwise, investors would dive into the stock, driving its share price up and thereby pushing its dividend yield lower. What is a good dividend yield for a stock? That depends largely on market conditions and the company's industry. Currently, dividends are relatively high owing to a general disdain for stocks and the lack of ownership of stocks among investors like us, referred to in the financial media in the aggregate as the retail investor. For example, you can get a health care company's shares, like Pfizer (PFE), which pays a 4% or 5% annual dividend yield or a utility such as PP&L (PPL). Most dividends in these industries are safe because we are coming out of a once-in-a-generation-financial collapse, when all companies who would have had to reduce their payouts would most likely already have done so. Dividends will rise in the coming years with stabilization in the global economy.

RPM's chart is ugly, but at these levels the stock is interesting.

Years ago I traded RPM International (RPM), and lately I have been interested in building a new position in the company's stock. Friday in the general sell off, the stock closed at $18.64 and currently pays a dividend of $0.21 or a 4.5% annual yield, which, at roughly 2.5% over Treasuries, indicates that either the market sees significant downside ahead for the stock price, namely another recession, or that traders have indiscriminately sold off RPM shares owing to their general disdain for stocks. I think that the latter is more likely the case, and that the current sell off in RPM shares presents a good opportunity to begin building a position in the company. RPM International is basically an industrial chemical company that sells all sorts of specialized  sealants and coatings. The company's most recognizable brand is Rust-oleum, but you probably have other products of theirs in your basement, workshop, or garage, like Dap, which is a popular brand of caulks and sealants. What will happen to RPM if we have a recession next year? RPM's stock price will go down, but chances are the company will do everything in its financial power to keep paying and increasing its dividend. For 37 consecutive years, RPM has raised its dividend, and that means it even raised its dividend during the Great Recession we just went through (and are still feeling). That sort of streak of dividend raises, of course, continues until it doesn't anymore, but RPM, with a streak that impressive, will likely continue it through the next recession, whether it occurs within the next year or five years hence.