What Makes a Safe Stock Safe?

Fortis Inc. (TSX:FTS)(NYSE:FTS) stock’s recent decline is used as an example to determine the safety of stocks.

| More on:

For most of the last decade, the market has valued Fortis Inc. (TSX:FTS)(NYSE:FTS) at a high price-to-earnings (P/E) multiple. Its normal P/E in that period was nearly 19. So, most of the time, investors paid a high multiple in exchange for the diversified utility’s safety and stability.

As safe an investment as Fortis may seem to be, the stock has declined more than 17% from its recent high in late November. Is the stock no longer safe? What made investors think Fortis was a safe stock to begin with?

A safe business generates stable earnings

Fortis is perceived to be a safe stock because it has demonstrated its ability to generate above-average, stable earnings over the long term. For example, if you graph the company’s earnings per share every year for the last 20 years, you’ll see that they form a general uptrend with small bumps along the way.

Over the years, Fortis has built an economic moat and has become one of the top 15 utilities in North America. Further, it has a reputation for its safe, growing dividend. In fact, it has increased its dividend for more than four decades! Only one other public Canadian company has achieved that feat.

Fortis generates more than 90% of earnings from regulated assets and generates roughly 60% of its earnings from the United States. Years down the road, people will still be using gas and electricity from Fortis. So, the company will still be around as the “Steady Eddie” business that it is.

The business is “Steady Eddie,” but the stock hasn’t been so as of late.

buy or sell

Is a stock safe? Look at its valuation

In an increasing interest rate environment, which is the environment we’re in, companies with lots of debt will be pressured. Fortis, including many other utilities, are just some of the companies that are under pressure.

Higher interest rates will dampen the growth of Fortis and other debt-heavy companies. That’s why we’re seeing multiple contractions in these companies. However, eventually, these stocks will be so cheap that the market will start bidding them up again. They’re not quite there yet.

How cheap is cheap? It’s hard to say. In the last recession, Fortis traded as low as a P/E of 14.2. Currently, at $39.70 per share, Fortis trades at a P/E of about 15.6.

When investors buy Fortis at a full valuation, they are essentially accepting the potential downside risk. Some of it has played out in the last two months or so. If Fortis had remained fully valued, it could still have delivered roughly market returns.

Investor takeaway

Some investors view safe stocks as companies with stable, growing earnings. However, investors need to do their part by paying an attractive valuation for stocks. Depending on the valuation investors pay, investors should be prepared for the different returns scenarios that can unfold. Next time such stocks are fully valued, will you take profits?

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Kay Ng has no position in any of the stocks mentioned.

More on Dividend Stocks

Dividend Stocks

Top Canadian Stocks to Buy Right Now With $1,000

Investing in stocks is not about timing but consistency. If you have $1,000 to invest, these stocks offer an attractive…

Read more »

cloud computing
Dividend Stocks

Is Manulife Stock a Buy for its 3.5% Dividend Yield?

Manulife stock has been a long-time dividend winner, but the average has come down over the last few years. So…

Read more »

Person holds banknotes of Canadian dollars
Dividend Stocks

This 7.5% Dividend Stock Pays Cash Every Single Month

Monthly dividend income can be a saviour, but especially when it provides passive income like this!

Read more »

jar with coins and plant
Dividend Stocks

2 High-Yield Dividend Stocks You Can Buy and Hold for a Decade

These TSX stocks still offer attractive dividend yields.

Read more »

concept of real estate evaluation
Dividend Stocks

Invest $23,253 in This Stock for $110 in Monthly Passive Income

Dividend investors don’t need substantial capital to earn monthly passive income streams from an established dividend grower.

Read more »

Dividend Stocks

3 Mid-Cap Canadian Stocks That Offer Reliable Dividends

While blue-chip, large-cap stocks are the preferred choice for most conservative dividend investors, there are some solid picks in the…

Read more »

The letters AI glowing on a circuit board processor.
Dividend Stocks

Is OpenText Stock a Buy for Its 3.6% Dividend Yield?

OpenText stock has dropped 20% in the last year, yet now the company looks incredibly valuable, especially with a 3.6%…

Read more »

calculate and analyze stock
Dividend Stocks

How to Use Your TFSA to Earn $6,905.79 Per Year in Tax-Free Income

Put together a TFSA and this TSX stock, and you could create massive passive income from returns and dividends.

Read more »