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By Josh Peters, CFA | 03-05-2014 01:00 PM

Where to Find a Margin of Safety

Income-focused investors should look beyond stock prices and instead focus on payout ratios, economic moats, and balance sheet strength, says DividendInvestor editor Josh Peters.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Where can investors find a margin of safety in today's market? I'm here with Josh Peters, editor of Morningstar DividendInvestor and also director of equity-income strategy, to find out.

Josh, thanks for being here today.

Josh Peters: Good to be here, Jeremy.

Glaser: Let's start off talking about market valuations. Where do you see stocks trading out right now? Is there a big margin of safety?

Peters: There is not a big margin of safety, but at the same time I wonder how often you actually need a big margin of safety, at least as it pertains to the stock price. The classic sort of Graham and Dodd type of thinking is figure a company is worth $10 a share, then maybe you try to pay $5 or you try to pay $6. To the extent that you can do that and your priority is capital gains, then the less you pay, the less you stand to lose if you are wrong and the more you stand to make if you are right. It's a pretty straightforward process.

I think that at least the way markets behave in this generation, certainly as long as I have been an investor, you don't necessarily want to buy the cheapest stocks, though for income purposes. It's much more important to find the margins of safety within the business that are going to protect the value of your income stream that you are getting through the dividend and the growth of the dividend over time than to look for something that is more of what I might call a statistical bargain.

Glaser: Income-focused investors maybe want to be looking at different metrics other than price. What are some important things to keep in mind?

Peters: Payout ratio is number one. This is the proportion of earnings that are being paid out as a dividend. So let's say a company earns $3 a share and pays out $2 a share; that’s a payout ratio of 67%. Now what's that number? Well just as in a price margin of safety, you would need to look at that level and the context of the variability of the business for a lot of reliable, steady, classic dividend-paying stocks in staples, tobacco, or utilities. A 60%-70% payout ratio is OK. There's no reason to think that in most of these cases earnings are going to plummet and stay permanently impaired at a level below the dividend if you are starting with that kind of a number. If it's a very variable or cyclical business, then that margin of safety needs to be bigger, which means that the payout ratio is smaller.

But that's how you have to think about it, and you want to make sure that there is enough of a cushion, so that if something goes wrong, either short term or long term, that impairs the company's profitability that you've got some cushion there for the dividend.

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