Investing in safe stock is particularly important if you want your wealth to reliably grow over time.
Blue chip companies can serve as the cornerstone of a long-term stock portfolio. This guide explains several of the critical ingredients in a safe stock, and how it all comes together.
Safe Stock: What to Look For
There are a number of things you can look for when it comes to determining the reliability of a given stock. Equities are of course never guaranteed, but by investing prudently, you can build long-term wealth and reliable investment income.
A Safe Stock Typically Pays A Growing Dividend
A reliable and mature company typically pays a good portion of its income out as dividends to shareholders. Newer companies are in high-growth phase and often need to reinvest as much capital as possible, but established, mature companies generally have free cash available. This type of safe stock pays dividends because there is no better place for their strong free cash flows; they can let money pile on the balance sheet in low-return accounts, or they can invest in their second-rate ideas, but preferably, they can give it back to shareholders as owner’s income.
Perhaps most importantly, a safe stock doesn’t just pay a dividend, it pays growing dividends. Several blue-chip companies have grown their annual dividends for 25, 40, or even 50+ consecutive years. The history is no guarantee for the future, but this type of record shows where management’s priorities are and shows the durability of the business model through several market cycles.
In addition, dividends diversify the returns for the investor. Rather than relying purely on capital appreciation, an investor in a safe stock that pays dividends benefits both from long-term capital appreciation and continual dividend income.
Good Historical Growth
Decades of consecutive dividend growth implies solid business growth over this period, but it’s worth stressing the concept of company growth as well. When examining a company, look at several years of revenue, operating cash flow, and net income, and see if they grow over time, and how smooth that growth is. Was it volatile during recessions? Or was it consistent?
Conservative Total Debt/Equity
Safe stocks have strong balance sheets. A weak balance sheet casts doubt on the company’s ability to reliably produce good returns year after year. Adding short term and long term debt together, and dividing this sum by shareholder equity, produces the total debt/equity ratio. For most companies, it’s advised that you look for a ratio of below 1. For utilities, MLPs, REITs, and other rather inherently defensive businesses, you can comfortably go a bit higher and still have a degree of safety.
Manageable Interest Coverage Ratio
Continuing the balance sheet discussion, the interest coverage ratio is a key ratio to look at. It’s calculated by dividing operating income by interest expense, and is therefore a measure of how many times over operating income can cover the interest expense. Different sectors have different safe numbers; asset-heavy businesses like utilities and MLPs that generally produce reliable cash flows can get away with substantial leverage and still be reasonably safe. More dynamic companies that can face stronger direct competition should generally keep interest coverage ratios higher if they want to be conservative. In a core holding for a non-utility, non-MLP stock, it’s often prudent to look for an interest coverage ratio of over 10.
Overall, what you really want to look for is the combination of total debt/equity and interest coverage. One or the other can potentially be fairly misleading by itself, but when put together, you can get a fairly quick and reliable view of the financial health of the business. If you want to dig deeper, it’s also worth checking out their credit rating, their debt/income ratio, and their current ratio.
A Competitive Moat is the Cornerstone of a Safe Stock
Not everything about looking for a safe stock is quantitative. There are qualitative factors at play as well. The concept of an economic moat plays a major role.
-Does the company have brand strength, economies of scale, and superior distribution systems to its competitors?
-Can customers switch to another business quickly, or are there high switching costs?
-Is this business basically a natural monopoly due to having infrastructure like gas pipelines, electric transmission, or rail tracks in strategic areas?
One or more economic moats is absolutely critical for a reliable company.
An otherwise safe stock quickly becomes risky if its valuation gets too high. Ideally, a stock valuation method should be used to ensure that the company is undervalued or fairly valued, rather than overvalued. If a company’s stock is overvalued, then even if the business itself does pretty well, its stock might not.
Putting It All Together
In conclusion, a safe stock is the cornerstone of a long-term wealth-building plan. A number of dividend growth companies spread across numerous sectors can act as the foundation of an equities portfolio, supported by some potentially riskier choices, broad indexes and other asset classes. Looking at quantitative ratios such as company growth, balance sheet, and stock valuation, and combining these with qualitative analysis regarding how well-positioned the company is, and then wrapping it all together by examining the dividend history of the business can be an efficient and effective way of finding reliable investments.
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