Finding a Margin of Safety in a Fully Valued Market

Note: This article is part of Morningstar.com's November 2014 Risk Management Week special report.

Investing in the stock market is an inherently risky endeavor. Morningstar StockInvestor editor Matt Coffina has identified 12 sources of risk in a stock portfolio, and that's really just the tip of the iceberg. Business risk, macroeconomic risk, regulatory risk, valuation risk, currency risk, and much more may send the risk-averse running for the closest bank CD. 

But for investors with a sufficiently long time horizon, this would be a mistake. Risk is not inherently a bad thing. Investors should be prudent about what risks they take on. But ideally, they are going to reap the rewards of a higher return for taking the riskier bet. 

The hard part is figuring out when you are being adequately compensated for the risk you're taking on and when you would be better off with a safer option. Throughout the week, we've tackled this question from many different angles--sharing insights on how to determine your risk tolerance and capacity, analyzing where the market is today, and hearing from several top fund managers about how they manage risk in their portfolios. 

One of the themes that came through this week is how important valuations are when considering risk. If you are buying a security at a huge discount to its intrinsic value, there is a large margin of safety against both known and unknown risks. An unexpected downturn or new piece of legislation or poor management decision that lowers the intrinsic value won't leave you with a permanent loss.  

But these days, there aren't very many values like that in the marketplace. According to our stock analyst team, the median stock is trading at 3% over its fair value estimate, and other measures of valuation also show that stocks are far from cheap. The market is priced for perfection, and margins of safety are razor thin, if they exist at all. Without this cushion, it is more important than ever to remain laser-focused on risk factors.

Now, being focused on risk is not a call to eschew equities altogether. Investors, as a group, have showed they are not very good at market-timing. It's very difficult to pinpoint the right time to get in or out. Instead, it's more sensible to stick to an asset allocation that is reasonable for your goals. Take the time to select reasonably priced, high-quality companies that you can comfortably hold for the long haul, no matter what short-term risk factors emerge. 

We screened our stock database to find some of these quality names. We started by looking only for wide-moat firms. Our analysts expect that these companies will be able to fend off competitive threats and continue earning economic profits for decades to come. These businesses aren't immune to business cycles, but they should hold up better over time. We also screened for firms with a low fair value uncertainty rating. This means that the analyst believes there is a relatively narrow range of outcomes for the business, giving the analyst a high degree of confidence in their fair value estimate. This confidence means we can accept a more modest discount to fair value before buying. Finally, because we don't want to overpay, we looked for firms that are rated 4 or 5 stars. You can run the screen for yourself by  clicking here.

To be clear, these names are far from risk-free, even if we think the businesses are more stable than average. In times of market stress, they are likely to experience very large short-term losses. They are still exposed to broader macroeconomic factors and are not a good substitute for short-term liquid assets or fixed-income exposure. 

Here are three firms that passed the screen:

 Baxter (BAX)
Current Price: $72 | Fair Value Estimate: $84
From the  premium analyst report:
"We think diversified health-care firm Baxter has earned a wide economic moat, stemming from economies of scale in plasma processing, injectable therapies, and dialysis products. Intangible assets--like Baxter's strong brands, patent protection, and pipeline productivity--also allow the firm to remain remarkably profitable in tough industries. More than 70% of Baxter's sales come from products with market-leading positions, and the safety and quality of its biologic therapies allow it to charge a price premium to competitors.

"Baxter's business is well diversified, reducing volatility of share prices and contributing to its low uncertainty rating. However, new competition for Advate from the likes of  Biogen Idec (BIIB) and  Novo Nordisk (NVO) over the next few years could begin to erode the firm's dominant position in the U.S. market for hemophilia A products if Baxter's pipeline fails."

 Procter & Gamble (PG)  
Current Price: $88 | Fair Value Estimate: $94
From the  premium analyst report:
"Procter & Gamble is working to right its ship. The firm previously entered too many new markets (particularly emerging markets, where competitors already have a leg up) too quickly, and new products failed to resonate with consumers, as evidenced by its languishing market share position. However, P&G's announcement that it intends to shed 90-100 brands--more than half of its existing brand portfolio, which in aggregate posted a 3% sales decline and a 16% profit reduction the past three years--indicates it is parting ways with its former self, looking to become a more nimble and responsive player in the global consumer products arena. We view this as a particularly important trait given the stagnant growth emanating from developed markets and the slowing prospects from emerging regions.

"Like others, P&G has fallen victim to weak and volatile consumer spending combined with persistent cost inflation that has yet to fully abate. At the same time, promotional spending over the past several years has conditioned consumers to expect lower prices, and lackluster innovation has, in some instances, failed to prompt consumers to pay up for its new products. Further, with more than 60% of its sales derived outside the U.S., P&G is exposed to foreign exchange rate fluctuations, which could have a negative impact on sales and profitability."

 Nestle (NSRGY)
Current Price: $75 | Fair Value Estimate: $86
From the  premium analyst report:
"As the largest packaged food and beverage firm in the world by revenue, Nestle is one of the leading players in several categories, including beverages, dairy products, confectionery, and pet care. The breadth of its product portfolio makes Nestle a core supplier to grocery stores across the world, and its distribution network is extensive. More than 20 of Nestle's brands each generate in excess of CHF 1 billion in annual sales, and the firm is particularly dominant in the bottled water category, fending off competition from beverage behemoths  Coca-Cola (KO) and  PepsiCo (PEP). As a result, Nestle is in a relatively strong position to negotiate with retailers for primary shelf space in stores, and we've afforded the firm a wide moat.

"Nestle's greatest operational risk is the threat of volatile commodity costs, which could squeeze margins. Although the rate of input cost inflation has moderated, the prices for several raw materials (including dairy, cocoa, and resin) remain elevated and show little signs of abating. Nestle operates in some competitive categories and faces stiff competition from companies such as Coca-Cola and Pepsi in bottled water,  Kellogg (K) in breakfast cereal, and  Mondelez (MDLZ) in confectionery. In addition, the quality of lower-priced products has improved in the past several years, and this could erode the premium that consumers are willing to pay for branded food products. Amid an environment of elevated unemployment and austerity measures, consumers are still price-sensitive in grocery stores. The frozen food category in particular has been a fierce battleground. Further, we recognize that Nestle's growth could slow because consumers who switched to private-label products during the downturn may not revert to leading brands as the economy recovers; however, the potential loss of any market share over time is unlikely to dent Nestle's wide economic moat, given the strength of its brands and the diversity of its product set."

All data as of 11/20/2014.