The Triple Margin Of Safety Approach To Dividend Investing

 |  Includes: BP, CL, JNJ, PEP, PG, RDS.A, RDS.B, WFC
by: Tim McAleenan Jr.

This is an article that discusses a strategy going forward that hedges your bets, segregating your assets into three different piles, each of which provide you a different kind of margin of safety going forward. It is a combination of value investing, high-quality blue chip investing at a reasonable price, and holding cash. Following this strategy gives you a margin of safety in three ways: price paid, quality and the flexibility and autonomy that comes with having cash on hand.

First, dedicate about a third of investable income to dividend stocks trading at a value. In this case, the margin of safety comes in the form of price. The point is that you will do reasonably well even if stock performance is so-so because your discount to intrinsic value purchase point acts as a shock absorber in the event that your business ownership stake experiences worse actual conditions than existed at the time you initiated your purchase.

Take something like BP (NYSE:BP). The company has sold off north of $30 billion in assets, the U.S. refining division is now losing money (as of Q3 2013), and the company's daily production is down to 1.1 billion barrels per day. Despite this cluster of bad news, the company still has a normalized profit engine of over $14 billion per year. In periods of normal pricing for commodities, BP usually has a dividend yield of 2-3% and trades at over 10x its annual earnings. John Neff, the legendary manager of the Vanguard Windsor fund, was on to something when he likened high dividends to hors d'ouevres that allow you to snack while waiting on the main meal (with the main meal being the time it takes a stock to transition from undervalued to fairly valued).

Even if BP loses its case on gross negligence grounds and has to sell off more assets, the safety inherent in the $45 per share price that currently offers a 4.8% dividend yield gives you room to make money several years from now because the current valuation gives you some safety as the company eventually approaches its intrinsic value.

Secondly, dedicate about a third of investable income to dividend stocks that possess the highest quality you can identify, selling at a reasonable price. When you buy assets that consist of the highest quality companies you find, your margin of safety is in the quality of the underlying asset rather than the price you paid. Even if you make the mistake of overpaying for your shares of the company, the high-quality nature of the underlying asset has a way of bailing you over long periods of time as the profits keep growing and the dividends keep accumulating.

A couple of examples. In 1999, Johnson & Johnson (NYSE:JNJ) traded at 31x earnings. A very dumb time to pay. Yet, even if you paid 31x earnings in 1999, you would have achieved annual returns of 7.51% since then. In the case of Colgate-Palmolive (NYSE:CL), the company traded at 33x earnings in 1999. Yet, since then, shares have compounded to give you total returns of 8.87%. For Pepsi (NYSE:PEP), shares were valued at 29x earnings in 1999, and yet the company has returned 8.13% annually since then. Procter & Gamble (NYSE:PG) was valued at 29x earnings in 1999, and yet has returned 7.12% annually since then.

By the way, none of this should be seen as a recommendation to buy overpriced blue-chip stocks. Rather, the point is that even with making the mistake of overpaying for a high-quality holding, you can still do quite all right for yourself when you let growing profits continuously compound upon themselves. Also, the point is to make you think: If paying 31x earnings for Johnson & Johnson in 1999 still yielded 7.51% annual returns, imagine the kind of returns you can get going forward today if you pay 15x normalized profits at the current price around $90 per share. With the best companies in the world, growth at a reasonable price investing can trump value investing with mid-tier companies, largely because of what happens when growing dividends get reinvested into a company that is still growing profits (this observation is the basis of Dr. Jeremy Siegel's work).

And thirdly, dedicate a third or so of your investable income to building a cash pile. When you look at the really good value investors, one common denominator among them is that they have a general tendency to have large amounts of cash on hand. Warren Buffett has explicitly stated a desire to keep $20 billion in cash on hand at Berkshire (NYSE:BRK.A) (NYSE:BRK.B). Charlie Munger has spoken publicly about how nice it was keeping large amounts of cash available to buy Wells Fargo (NYSE:WFC) in 2009 and 2010. At the Baupost Group, Seth Klarman regularly keeps a third of all assets under management in cash so that he will be prepared to strike when opportunity arises.

The logic behind holding cash is two-fold. Sometimes, cash is regarded ambiguously as an overflowing emergency fund. In those situations, the rationale is to follow Benjamin Graham's advice to position your financial life so that you never have to sell stocks when you're unwilling, out of the need to meet an emergency in your personal life.

Other times, cash is regarded as a portfolio holding itself (as in, when someone makes the tactical allocation to put 20% of their assets in cash so that they may deploy that money when the next wave of pessimism strikes stock market prices). In this situation, the wisdom to build up cash now is driven out of a desire to be able to make larger investments during the next crisis then the immediately available funds from your regular income would allow. Generally, several years of a booming stock market could make it wise to build up cash on the simple bet that we're overdue for a down year sooner rather than later.

With these things said, it is important to keep in mind that holding cash is one of those areas where there is no right answer. Considering that stock-picking is an endeavor that only requires you to identify one attractively priced stock at a given time, it doesn't matter what the market as a whole is doing as long as you can find something cheap.

And plus, cash is inherently non-productive. Someone holding Royal Dutch Shell (NYSE:RDS.B) (NYSE:RDS.A) will collect north of $11 in total dividends per share over the course of the next three years. If you have to wait three years to get your price with a certain stock, that is $11 in total dividends on every $70 invested in which you would be missing out. So I don't pretend to think that the wisdom of holding cash is something that is by any means a requirement for successfully investing from here on out.

Instead, this three-pronged approach gives you a margin of safety in three ways. It calls for you to buy some good companies at a decent price, in which part of your portfolio is protected by the price you paid for your investment. It calls for you to buy some excellent companies at a reasonable valuation, in which case the resilient nature of the products being sold serves as your margin of safety. And it calls for holding cash, which gives you options. It is that flexibility to maintain your autonomy that is the source of your third margin of safety. When you blend those three attributes together, you can put yourself in a position to prosper well over the course of the next five years as this safety ensures that you will be pretty well covered to grind forward even if the economic recovery starts to slow down.

Disclosure: I am long JNJ, PG, BP, RDS.B. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.