Have you come across a company you think might be a worthwhile investment but you don’t know how risky the company is? This is a method I use to quickly determine a company's risk level. Many companies are covered by analysts but you often have to pay to receive their reports. In other cases, if you use a discount broker, their website will have various analyst reports that are available to you at no additional cost. In some cases you walk away puzzled because some analyst reports recommend “sell”, “hold”, and “buy” all at the same time. As I write this article, my discount broker has 5 different analyst reports on 3M. Three rate it a “hold”, one rates it a “buy”, and one rates it a “sell”.
This is why I use a quick and rudimentary method to quickly determine a company's risk level.
I check to see if the company’s credit ratings (Standard & Poor’s, Moody’s Investor Services, Fitch Ratings, Dominion Bond Rating Service Ltd.) are posted on the company’s website.
In other cases I perform a search for credit ratings and do not get the results for which I am searching. In these cases I go to the Investor section of the company’s website and I will look up recent Securities and Exchange Commission (SEC) Filings.
I look for “424B2" filings. This is the prospectus form a company must file if it is making a primary offering of securities on a delayed basis. It includes information about the security being offered such as the price set for the public offering and the method of distribution.
On October 31, 2016, United Technologies (NYSE: UTX) filed a prospectus pursuant to rule 424. This particular prospectus does not reflect the company’s credit rating. It does, however, show the rate of interest to be paid on the securities being issued.
Looking at the interest rates on these securities on a stand-alone basis is meaningless. I compare these rates to the 3, 5, 7, 10, 20, and 30 “risk free” rates found at the following site:
As at December 2, 2016, these “risk free” rates are: 1.40%, 1.84%, 2.20%, 2.40%, 2.78%, and 3.08%.
The rates United Technologies will pay on the new securities are reasonably close to the “risk free” rates. This gives me some comfort it is credit worthy; the risk of defaulting on its obligations is remote. Based on my parameters, this company warrants more research.
If the company in which I wish to invest is Canadian and is issuing securities in Canadian dollars, I compare the rates to those found on:
As at December 2, 2016, the “risk free” rates for 2, 3, 5, 7, 10 and “long” rates are: 0.50%, 1.75%, 0.75%, 1.50%, 1.50%, and 2.75%.
The long rate is to December 1, 2048 and yes, the 3 year rate is higher than the 5, 7, and 10 year rates!
Let’s look at two companies with higher risk profiles that do not meet my risk tolerance level.
Student Transportation Inc.
I accessed Canadian Securities Administrators ' SEDAR website to look at recent filings for Student Transportation Inc. (NASDAQ: STB and TSX: STB).
I found a filing of the 3 month financial statements ending September 30, 2016 and 2015 uploaded November 9, 2016 on SEDAR. Within the notes of the financial statements I found the following:
"On August 16, 2016, Student Transportation Inc. issued 5.25% convertible unsecured subordinated debentures due September 30, 2021 at a price of $1,000 per debenture, for total gross proceeds of $85.0 million."
5.25% for the 5 year subordinated debentures does not compare favorably with the 5 year Canadian Benchmark Bond Yield of 0.75%. Given that common shares rank after convertible unsecured subordinated debentures in the event of liquidation, Student Transportation is too risky to warrant any research.
Seaspan Corporation (NYSE: SSW) is a company for which I have seen a few articles on Seeking Alpha. This is a hub where investors post articles about various companies they have analyzed.
When I go to Seaspan’s website Seaspan Corporation Financial Information and look up SEC filings, I see a prospectus filed pursuant to Rule 424 on November 7, 2016. I see 4 Preferred Share issues bearing rates between 7.875% and 8.25%. These rates do not compare favorably with the US “risk free” rates.
I recognize I am comparing debt versus preferred shares rates. The disparity in rates, however, is enough to make me pass on conducting any further due diligence.
What if the company has no debt? This can mean two things.
In some cases the company is so risky nobody will lend it money or buy any debt even if it succeeded in raising debt. Examples of this would be a junior mining company or a biotech company with no revenue stream (it might only have drugs in Phase 1 or Phase 2 stages of testing); these companies typically raise equity. I have absolutely no interest in investing in such companies.
Other companies like Microsoft Corporation, Nike Inc., Automatic Data Processing, Inc., and Paychex, Inc. have minimal or no debt. In some cases, companies have been so profitable the use of debt has not been required or, if it ever was required, it has been repaid. I will definitely roll up my sleeves and conduct more research for such companies.
This is not the only way to quickly determine which companies are too risky for your level of comfort. Let me know the process you follow to cull the universe of companies that may be worthy of your hard earned money.