Retirement Income Equity Selection Factor 4: The Nature of the Business

By: Bruce Miller, CFP®

Some of the retirement income equity selection factors that I already described in my previous articles — like the dividend yield or the dividend growth rate — have specific formulas and can be easily quantified for use in an objective assessment. However, the nature of the business — while an equally important selection factor — cannot be quantified as easily as the yield or the growth rate. The nature of the business relies on using common logic and simple analytical thinking to deduce which industries have growth potential and which do not.

For example, it is reasonable to assume that energy will be part of our future. Fossil fuels — regardless of how much we wish to use fuels that put less carbon dioxide into our atmosphere — will be with us for decades to come. What could undo this assumption? Well, harnessing nuclear fission might be one and finding ways to create and store anti-matter might be another. I’m not being facetious. Both are possible.

Although certainly possible, most investors will not consider global climate change an income risk that would keep them from owning an income stock such as Chevron (NYSE:CVX) or ExxonMobil (NYSE:XOM).

When we consider a company such as Pitney Bowes (NYSE:PBI) — a company in the business of manufacturing postal sorting and mailing equipment — it should be apparent that such an industry has very limited growth potential. The internet has gradually replaced the methods by which we communicate with each other as well as the methods by which we send the documents that we used to simply stuff into envelopes and mail.

When I first began to invest in the late 1990s, I discussed this possible retirement income risk with other analysts and investors. We agreed there was too much risk around a company that derived almost all its revenue from the manufacture of mail processing equipment. After 31 years of dividend growth, PBI cut its dividend in May 2013.

The future need for the products or services is a prime concern. Having said that, be mindful that the future market demand for the products or services of a company is not sufficient to be able to reliably predict the company’s ability to sustain and grow its dividends. For instance, U.S. Airways declared bankruptcy despite filling most or all of its airline seats.

Another income risk in this tough-to-quantify selection factor includes companies with single products or companies which derive most of their retirement income from either a single or a few products. The lack of product diversification makes a company susceptible to regulatory changes, changes from their competition or consumer product liability issues. Examples that spring to mind include companies such as Microsoft (NASDAQ:MSFT) and Altria (NYSE:MO). However, one can temper these apparent risks by considering how well the company has held its market share, how likely it can be replaced through competition or even its experience in past product liability cases.

I find it helpful to read the opinions of independent analysts — such as Morningstar. Morningstar’s analysts will often offer insights that I had not considered as they have developed a ‘moat’ system of qualitatively describing a company’s ability to sustain its cash flow with a broad range of diversified products. Additionally, the opinions on Morningstar can tell me which companies have full control over their market products or services and thus make it more difficult for competitors to enter the market and compete.

A final comment on these selection criteria has to do with ethics. Should one hold an income security that belongs to a company which manufactures products that have proven to be dangerous to its users? This question is closer to a personal choice, rather than being a business or market decision. Without a doubt, Altria would fall into this category.

To be clear, owning or not owning shares of Altria does not make them profitable or unprofitable. Therefore, I personally do not feel that I am adding to their business model by owning their stock. Buying their products or abstaining from buying their products does do this, however.

However, the question of whether I am comfortable owning a stock and participating in the net cash flows of a company like Altria remains salient. There is no easy answer to this question, and the answer depends on the personal preferences of the retirement income investor. Personally, I have concluded that most companies are involved in products that can cause damage, that consumers are well informed as to what the risks of a product are and that some individuals enjoy products despite their risks.

If I shun this or that product for its potential to do harm, where should I draw the line? Should I disregard Unilever (NYSE:UL) because it owns Ben & Jerry’s Ice Cream? After all, Ben & Jerry’s Ice Cream products are loaded with saturated fat and cholesterol. These clog arteries and accelerate the onset of cardiovascular disease and premature death.

As a result, this dilemma can quickly become a slippery slope. How are we to adequately define and make clear demarcations between what qualifies as an ‘ethical’ stock and what does not? This is a decision that each income investor will have to make individually.

In the next article, I will conclude my discussion about retirement income selection factors by discussing the last of the five factors — dividend coverage.

Bruce Miller is a certified financial planner (CFP) who also is the author of Retirement Investing for INCOME ONLY: How to invest for reliable income in Retirement ONLY from Dividends and IRA Quick Reference Guide.