Margin of Safety
Margin of Safety. Most investors don’t really understand when to buy a stock. I did not when I first started out. I had no idea about valuation and margin of safety. Ideally, you would like to buy a stock when it is undervalued rather than when it is trading at nosebleed valuations. You would like to build in a margin of safety so there is a cushion for the downside. It helps cushion the blow if you are wrong in your investment thesis, you are in effect managing the downside. Granted, there are stocks that trade at elevated valuation year-in and year-out. Amazon (AMZN) and some other megacap tech stocks come to mind. Some investors will always point to these stocks and say it was overvalued last year based on price-to-earnings ratio and the stock went up. It is overvalued this year too and I think it will go up again. However, there are always exceptions to the general rule.
What Happens if There is No Margin of Safety?
In reality, buying an overvalued stock tends to lead to poor returns over the subsequent years. That is where the margin of safety comes in. But first let’s take a look at an example. I invariably use Cisco (CSCO), a stock I own, for this type of valuation example. During the dot-com bubble Cisco was trading at a record high and had the largest market capitalization. The stock reached a peak valuation of roughly $555 billion. Cisco’s stock price plunged during the dot-com bust. It has yet to reach the high of that era.
The chart below shows that investing in Cisco in mid-March 2000 when the stock had a P/E ratio of nearly 200X and before the bust and holding the stock for 10-years would give you a total annualized return of -11%. Cisco did not pay a dividend during that time, so you did not do any better with dividends reinvested. The problem was that there was no margin of safety. You exhibited too much optimism and were willing to pay a premium for a stock that was likely trading well above its intrinsic value. When the economy slowed Cisco and other stocks trading at such nosebleed valuations tumbled.
A Different Scenario with a Margin of Safety
What if you invested in mid-March 2011 when the stock had P/E ratio of 12X to 13X and are still holding the stock? You did much better. You are paying for a stock that was likely trading below the broader market valuation or even a reasonable valuation of 15X to 16X. There was a built-in margin of safety. An economic slowdown will probably not decimate the stock price. In this scenario you generate a total annualized return of 13.3% with dividends reinvested. Cisco started paying a dividend in 2011. That’s not bad for an old tech stock whose glory days are perhaps behind it.
How Do You Determine Margin of Safety?
What is the percentage below the fair value estimate that you are willing to pay for a stock? To put it more simply, what is the market price, what is the estimated intrinsic value of a stock, what is the percentage difference, and what are you willing to pay based on your risk tolerance? The margin of safety is the difference between the price you are willing to pay and the market price.
The market price is easy to determine. How do you determine an estimated fair value? You can use a valuation model like the Gordon Growth Model, discounted cash flow model, or P/E ratios. I use all three and take an average. The valuation models are not perfect nor is the method, but they provide more than a shot in the dark. Investing is humbling, some of your stock picks will do well and become a 10-bagger or better, some stocks will go nowhere for years, and unfortunately some stocks will generate losses. A margin of safety can help cushion the blow when you are wrong.
Thanks for reading about margin of safety? What are your thoughts?
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Dividend Increases and Reinstatements
Alliant Energy (LNT) raised the dividend 5.9% to $0.4025 per share. The forward yield is about 3.3%. Alliant Energy has paid a continuous dividend since 1946. This is the 17th straight annual increase. Alliant Energy is a Dividend Contender.
Consolidated Edison (ED) hiked the dividend 1.3% to $0.775 per share. This forward yield is 4.5%. This is the 46thstraight annual increase. Consolidated Edison is a Dividend Champion and Dividend Aristocrat.
Coronavirus Dividend Cuts and Suspensions List
I updated my coronavirus dividend cuts and suspensions list this past Wednesday. The number of companies on the list has risen to 511. We are well over 10% of companies that pay dividends having cut or suspended them since the start of the COVID-19 pandemic.
No new companies were added to the list in the past week.
I included one company that I had previously missed. The one company that I previously missed was RioCan Real Estate Investment Trust (RIOCF).
Dow Jones Industrial Averages (DJIA): 30,997 (+0.59%)
NASDAQ: 13,543 (-4.19%)
S&P 500: 3,841 (+1.93%)
Market Valuation – Margin of Safety
The S&P 500 is trading at a price-to-earnings ratio of 38.7X and the Schiller P/E Ratio is at about 34.9X. These two metrics are up this past week. Note that the long-term means of these two ratios are 15.8X and 16.7X, respectively. I continue to believe that the market is overvalued at this point. I personally view anything over 30X as overvalued. Note that we are starting to approach 40X and valuation levels near the top of the dot-com era.
S&P 500 PE Ratio
Shiller PE Ratio
Stock Market Volatility – CBOE VIX
The CBOE VIX measuring volatility went up this past week by almost three points to 21.91. This is barely above the long-term average but still a low value. The long-term average is approximately 19 to 20. So, at this point we are just above the long-term average and trending down.
Fear & Greed Index
I also track the Fear & Greed Index. The index is now in Greed at a value of 69, up 9 points from last week.
There are seven indicators in the index. They are Put and Call Options, Junk Bond Demand, Market Momentum, Market Volatility, Stock Price Strength, Stock Price Breadth, and Safe Haven Demand.
Market Momentum is indicating Extreme Greed. The S&P 500 is 9.44% over its 125-day average. This is on the higher end over the past two years.
Stock Price Strength is signaling Extreme Greed. The number of stocks hitting 52-week highs compared to those hitting 52-week lows is at the upper end of its range.
Stock Price Breadth is indicating Greed as the advancing volume is 6.27% more than declining volume on the NYSE. This is near the higher end of its range over the past two years.
Safe Haven Demand is in Fear. Stocks are still outperforming bonds by 5.6% over the past 20 trading days. This is close to the strongest performance difference over the past two years and indicates that investors are rotating into stocks.
Market Volatility is set at Neutral. The CBOE VIX reading of 21.91 is a neutral reading.
Junk Bond Demand is indicating Fear. Investors are accepting 2.18% yield over investment grade corporate bonds. This is historically low but is elevated compared to recent levels.
Put and Call Options are signaling Extreme Greed.
The number of weekly new unemployment claims were up with last week at 900,000. This is up 26,000 from last week’s revised numbers. After falling below 800,000 for several weeks the new unemployment claims started to trend up several weeks ago. The 4-week moving average is over 800,000 and trending up.
For some perspective, one-year ago weekly unemployment claims were only about 220,000. Currently we are 3X – 4X the normal level. The seasonally adjusted insured unemployment rate was 3.7%.
The ten states with the highest unemployment rates were Kansas (7.5), Pennsylvania (7.2), Alaska (6.6), Illinois (6.1), Nevada (5.9), California (5.8), Puerto Rico (5.8), New Mexico (5.7), Colorado (5.6), and Minnesota (5.5).
The U.S. Census Bureau reported new residential building permits were at a seasonally adjusted rate of 1,709,000 in December, which is 4.5% above November’s revised figure. December’s building permit figure is up 17.3% year-over-year and the highest since 2006. An estimated 1,452,000 housing units were authorized by building permits in 2020 up 4.8% over 2019. December housing starts were up 5.8% over November’s revised figures to a rate of 1,669,000. Single-family housing starts in December were at a rate of 1,338,000, 12% above the revised November figure of 1,195,000. The 12% increase was the eighth straight, the longest in 50 years. Construction climbed in three of four regions, led by a 32.1% increase in the Midwest, with starts in the Northeast showing the only decline, down 34.8%.
The National Association of Realtors reported existing-home sales rose 0.7% in December for a seasonally-adjusted annual rate of 6.76 million homes. Sales in total climbed 22.2% year-over-year. Total year-end sales was 5.64 million units which is the highest level since 2006. The median price of an existing home was $309,800, a 12.9% increase over December 2019. December’s unsold inventory stood at only 1.07 million homes, down 23% year over year. Unsold inventory is at an all-time low 1.9-month supply, which us the lowest number of homes since 1982, with 70% of the homes sold in December 2020 on the market for less than a month.
Thanks for reading about the Margin of Safety and the Dividend Power Week in Review.
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Prakash Kolli is the founder of the Dividend Power site. He is a self-taught investor, analyst, and writer on dividend growth stocks and financial independence. His writings can be found on Seeking Alpha, InvestorPlace, Business Insider, Nasdaq, TalkMarkets, ValueWalk, The Money Show, Forbes, Yahoo Finance, and leading financial sites. In addition, he is part of the Portfolio Insight and Sure Dividend teams. He was recently in the top 1.0% and 100 (73 out of over 13,450) financial bloggers, as tracked by TipRanks (an independent analyst tracking site) for his articles on Seeking Alpha.