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Where to Find a Margin of Safety

Josh Peters, CFA

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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Glaser: How about economic moat?

Peters: That's absolutely essential. This is a qualitative factor for the most part. It certainly reflects itself in figures like return on invested capital, that the company has some defensible sustainable competitive advantages or edges versus its peers that will lead to superior returns.

Typically, you need those for protecting the dividend, too, over very long period of time. You want to know that the business, say a food company, for example, that they are an efficient manufacturer, they've got some scale, and they've got some important brands that people pay a little bit more for so that they're not totally at the mercy of competition, and that whatever you're looking at for current earning power is more likely to be a good reflection of the longer-run earning power.

Your no-moat businesses are the ones that are more likely to cut their dividends. Typically those fields might be super cyclical businesses. If an airline starts paying dividend, believe me I'm not going to be slightest bit interested, or the same of commodity producers of one kind or another. Those are the names I think you want to stay away from, and requiring that narrow or wide economic moat really helps with that process.

Glaser: What are some other red flags that maybe are not going to be getting a margin of safety? Balance sheet strength? Anything else investors should keep an eye on?

Peters: Balance sheet is another big area that you have to take a look at. If there is some variability or long-term threat to the business for equityholders, it's magnified by whatever debt there is on the balance sheet. And typically what you are going to want to look for are companies that have moderate payout ratios that are high enough to provide a good dividend yield--but not so high that they'll be cut at the first sign of trouble--that have a narrow or better yet wide economic moat, and that have low levels of leverage. I'd like to look for companies that we at Morningstar will rate with investment-grade credit ratings preferably A, AA, AAA.

Those factors put together, the underlying business can be very stable. Now it doesn’t mean the stock couldn’t be overpriced, but I would rather pay up to our fair value estimate, up to a fair price for a very high-quality business where I can count on the dividend and I can have a very high degree of confidence in continued growth in the dividend rather than to look at much lower-quality businesses that maybe happen to have that higher yield. But I just can't expect to be able to rely on that.

There really isn't a margin of safety big enough that's going to make me want to buy Windstream, for example, for income. The stock has been yielding 12%-13% lately, and it looks cheap on a lot of metrics, but as the business continues to erode, there is a very good chance as it gets larger and larger over longer periods of time that dividend gets slashed. I don't think there is a margin of safety that I can get in terms of paying the price for the stock that will protect my income from being reduced in that event.

Glaser: Income investors don’t need to be solely focused on price, but they can't completely ignore it either. You mentioned paying up to fair value. Are there any circumstances where you would go above that, or is that just too much of a red flag?

Peters: I might hold very high-quality businesses even if they go above our fair value estimates for a while because those very high-quality businesses will pull the value along with the stock price. They'll find ways of creating value in some cases where you didn't expect. Realty Income is a good example. I held that stock when it moved above fair value for a while, and now it looks like maybe it was a good selling opportunity. But if I sell a name like that, I might not get the opportunity to buy it or might not be smart enough to see the next buying opportunity. I miss out on what could be decades of additional dividend growth that's going to drive a lot of total return from a higher-yielding stock like that.

In some other cases, such as with lower-quality businesses, maybe I didn't realize that they didn't really meet my standards when I bought them. I look to get rid of those even at prices under fair value because I want to respond more to the fundamentals of the business and how that translates into dividend safety and dividend growth.

Valuation is important, but it's, I think, one of the later steps as you're looking at a business. If you're investing for the dividend, you need to prove out a lot of other things and look for those margins of safety inside the business before you get to the stock price.

Glaser: Josh, thanks for your thoughts today.

Peters: Thank you, too, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser.

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