Peters: No Margin of Safety in Market Today

Glaser: I'm Jeremy Glaser with Morningstar.com. I'm here at the 2010 Morningstar Stocks Forum joined by Morningstar DividendInvestor Editor Josh Peters to see what to do when you don't see a lot of good options in the dividend market.

Josh, thanks talking with me.

Peters: Good to be here.

Glaser: A lot of people have been looking for great yield picks. I know you get asked all the time and we're always pushing you to give us new names, but sometimes there just aren't a lot of really great options in the marketplace. Is that what you're seeing right now?

Peters: Unfortunately, it is, and I guess that's part of the honor, commitment or something of somebody in my position. I was looking out over the investment landscape and trying to provide good reasonable conservative investment recommendations. It's that some times you just have to fess up and say that the cupboard is bare or at least in this case the cupboard is bare in terms of the traditional sorts of bargains, margins of safety from Graham and Dodd language that you want to try to find even among good businesses. It just very tough right now.

Glaser: If it's so difficult to find those kinds of bargains, but you still have money that you want to put into long-term equities that you need that yield what should you be looking at right now then?

Peters: Well, to me I think you have to start by evaluating your time horizon, which is, am I able to put capital to work for a 5, 10, 15, 20-year type of time horizon. Whether it's before retirement or after retirement. Can I keep the capital at work for a very long period of time, enough to smooth out a lot of the volatility, a lot of frankly uncertainty that is going to transpire even over relatively long time horizons from here.

If you can't, then you just kind of have to stick with money market instruments and cash and CDs at the very short end, because there is just no way of guarantying or even having a lot of confidence in the ability to get your money back when you might need it. So, it has to start with that long-term time horizon.

Then I think you spread the menu out and you look at is there a cash component that you want to try to time the market with, maybe you can get stocks cheaper or bonds cheaper. I think that's a poor strategy as part of a permanent deployment of capital just because how will you know when the market is cheap enough to actually get in. You might miss the downswing and miss the upswing with that approach. So, to me it's really coming down to the sort of the bond versus stock debate. Or nearly you'd think well bonds should be for capital preservation and some amount of income in stocks for the growth. But bond yields are so low right now even over long durations that they are not providing a lot of income and they are presenting frankly a lot of risk in terms of future inflation.

So, I almost feel cornered, I might like to have a very balanced strategy, I feel I'm essentially being forced in the stock market even though it's not objectively cheap, because it's only stocks that are capable of generating those real returns that can compensate for inflation actually put your head at the end of the day. And even then from there you have to be very picky, it's not just dumb market in general. Remember the yield on the stock market in general right now is still under 2% that's still not great. You have to be very picky within the stock market, what's kinds of individual companies you want to invest in.

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Glaser: Given that you think there is going to be so much uncertainty, what kind of stock should you look at if you decide that your money really should be in the stock market?

Peters: Well, I think there are two components to look at, one is the yield component and this is almost a matter of personal preferences as how much income do you need to generate right now. Frankly, the stocks that have bigger dividend yields in a relative basis are just as expensive as the rest of the stocks in the market, in some cases even a little more expensive. So, it's not like you're going to be getting great bargains, with great potential upside. But the ability to get even a 4% or 5% type of dividend yield from very high quality names, there you're putting half of an expected long run return of 8% to 10% in your pocket, you're not leaning heavily on growth, you're not assuming a lot of capital appreciation. If you don't get it, it probably won't throw you off track.

The other component is to stick with very, very high quality names and that's the same litany of things that I've been looking for here for almost six years. Well, narrow and wide economic moat, those companies that have strong competitive positions critically an ability to at least maintain or raise prices in line with inflation over time, protect the purchasing power of the company's income stream, and its dividend streams to shareholders.

Conservative financial position. I mean we don't really know if the economy might slip back in the recession, there is no point in investing in a business that maybe very heavily burdened down by debt. Right now credit market standards are pretty low and yields are pretty low, it's pretty easy to borrow that may not last forever. You don't want to necessarily buy stock in something that has to continually access the capital markets.

Now, dividend policy becomes very important. Are you seeing that you're being rewarded directly from the growth of the business? Is the business itself growing? Is there some secular growth tailwind that is going to provide you with the basis to expect even a couple of percentage points of internal growth from the business over the long-term?

It's like the difference between saying McCormick spice and seasoning's company. There is more people on planet earth, there is going to be more food eaten, and people are going to want more seasoned food, especially in foreign countries. As developing countries become wealthier they should be buying more packaged foods more seasonings.

Now, there is a gentle. However, gentle it maybe there is a long run tailwind there. If you're looking at fixed line telecom there is a long-term secular headwind people continuing to cut the cord on the copper pair that runs into their house.

I mean these kinds of factors, they reinforce the basic type of message that I've had about stock selection for a number of years now, but I think it becomes even more important in this kind of environment when there is just no abundance of price discounts, bargains, margins of safety however you want to describe on that are going to compensate you for accepting lower quality businesses.

Glaser: So if you're going to have to pay up you might as well pay up for the best?

Peters: That probably is the best way of putting it. Don't think in terms of trying to make the most money. Think in terms of trying to take the least risk.

Glaser: Josh thanks as always.

Peters: Thank you Jeremy. Good be here.

Glaser: For Morningstar.comm, I'm Jeremy Glaser.