Watch Out For Hidden Risks

Have you ever heard of Succession Risk? It occurs when key leaders of a company leave their position—whether expected or not—and a clear successor isn’t already in place.

When key leaders leave, there is a loss of both knowledge and experience that can be hard to replace. And there is always a lag getting someone new up to speed, even though that can be minimized with an internal promotion.

It often creates uncertainty among shareholders that ends up being priced into shares.

That’s exactly what happened to The Clorox Company (CLX) last week. Chairman and Chief Executive Officer Linda Rendle decided to step down for health reasons. The plan is for her to remain in office while a search is conducted and then through a period where she will act as an advisor.

The stock was already struggling, and CLX shares slid another 6% on Friday on the news.

Now, I still like CLX as a long-term holding, and I think some new blood in the C-suite could be a good thing. But still, markets are clearly trying to quantify the risks during this succession period and price it into the shares.

Personally, I will grab a few more shares at an even lower price.

This is another example of “hidden risks” that can sneak into your portfolio. On the surface, they can spook investors and erase your gains, even if just temporarily. On a deeper level, they can disrupt a company’s operations, negatively impact earnings, and cause our dividend payments to become vulnerable.

Let’s take a look at other risks.

Some Risks Can Be Measured

It is hard to put a specific dollar amount on the succession risk for Clorox (despite the market trying anyway). But there are risks that can be measured.

One is key customer concentration risk. This becomes an issue when a few customers—or maybe even a single customer—make up a large share of a company’s revenue. This also applies if your customers are concentrated in a specific industry or geographic location.

An example in the news is Booz Allen Hamilton Holding Corp. (BAH). Roughly 98% of its revenue comes from government contracts, and dozens of them were cancelled over the past year. This included 31 contracts with the Treasury Department cancelled in January. Shares are down 20% over the past year while the overall market is at all-time highs.

We can put into numbers the revenue that would be lost if a specific customer or contract falls off the balance sheet.

Another risk that’s incredibly relevant right now is refinancing risk. This occurs when a company has debt maturing that must be refinanced. Debt issued at low interest rates during 2020-2021 may end up being replaced by debt at much higher interest rates. That raises finance costs and can eat into free cash flow and possibly into our dividends.

Lastly, there’s currency risk. As a dividend investor who looks for long-term holdings, I always hold some global consumer staples giants.

These companies earn revenue in multiple currencies that must be converted into their reporting currency. Changes in exchanges rates can impact both earnings and forward guidance numbers. This is another thing to consider when investing in foreign companies.

Analysts are continually running the numbers to estimate the impact these risks will have on future earnings and dividend health. Some risks, however, require a more creative approach.

And Other Risks, Not So Much

Potential hazards such as regulatory risk and litigation risk are much harder to measure. Instead of the spread between interest rates or the percentage of revenues, we are talking about complex probability models.

Both of these risks can severely impact a company’s future profits and be largely beyond its control. I always have pharmaceutical and tobacco companies in my portfolio. They both rely heavily on the decisions of regulators, specifically the FDA.

Pfizer (PFE) needs approvals on new drugs in its pipeline to offset patent cliffs. And Philip Morris (PM) still sells its outdated IQOS heated tobacco device here in the US because it’s waiting on approval for its new model.

Litigation risks are even harder to measure as they can pop up out of nowhere.

That brings me to the most top-of-mind risk—technology disruption risk. These days, it might be more accurate to call it AI adoption risk. This concern ripped through software stocks in the first quarter and is far from over.

I’m still not convinced that AI is ready to take on most tasks today… or in the near term. But it will for sure change the future of many companies, industries, and professions. And analysts are trying to measure the risk.

None of these risks should be instant deal breakers when screening for stocks to add to your portfolio, but you want to recognize when they are present. For some stocks, you might be able to use temporary risk speculation to lock in an even better price, and in turn a higher yield.

Do you consider these risks when you add new positions to your portfolio? What other hidden risks are you watching for in the current economy?

For more income, now and in the future,

Kelly Green