Benjamin Graham: How to Prevent Losses With a Margin of Safety

Following Benjamin Graham’s footsteps, what should you do with dividend stars such as The Coca-Cola Co (NYSE:KO) when they’re expensive?

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The Coca-Cola Co (NYSE:KO) and PepsiCo, Inc. (NYSE:PEP) have long been the core holdings of many dividend portfolios. Who can resist these dividend-growth stalwarts?

Coca-Cola and Pepsi have increased their dividends for 54 and 44 consecutive years, respectively. Only one Canadian company has raised its dividend for 44 years.

I’ve always treated Coca-Cola and Pepsi as core holdings. However, I parted with my last shares of both companies because of one simple reason–there’s no margin of safety.

“There is no such thing as a good or bad stock; there are only cheap stocks and expensive stocks. Even the best company becomes a “sell” when its stock price goes too high, while the worst company is worth buying if its stock goes low enough.” —The Intelligent Investor by Benjamin Graham with new commentary by Jason Zweig

Margin of safety on their prices

When I sold, both were trading at more than 23 times their earnings. They last traded at these expensive multiples in late 2007 before the financial crisis. I’m not implying there’s a causal relationship between the high multiple and the crisis.

However, whenever a stock trades at an expensive multiple, eventually it will revert to the mean. So, if their growth slows and their multiples contract, Coca-Cola and Pepsi could revert back to their normal multiples. Their five-year normal multiples are 19.4 and 18, respectively.

From their current prices to their normal multiples, Coca-Cola could fall 17% to under US$38 per share, and Pepsi could fall close to 20% to under US$85 per share.

So, there’s no margin of safety on their prices. What about their dividends?

Margin of safety on their dividends

At under US$46, Coca-Cola yields almost 3.1%. Its quarterly dividend is US$0.35 per share, equating to an annual payout of US$1.40 per share and a payout ratio of roughly 70%.

This is the highest payout ratio Coca-Cola has ever had. Additionally, earnings growth is expected to be about 5% in the medium term. So, Coca-Cola’s dividend-growth rate should logically be lower than previous years if the company doesn’t want to expand its payout ratio.

There’s a margin of safety for Coca-Cola’s dividend as it’s still retaining about 30% of its earnings.

At under US$106, Pepsi yields 2.8%. Its quarterly dividend is US$0.75 per share, equating to an annual payout of US$3.01 per share and a payout ratio of roughly 66%, which is slightly better than Coca-Cola’s.

This is the highest payout ratio Pepsi has ever had. Its earnings growth is estimated to grow 6.5% in the medium term. So, Pepsi’s dividend-growth rate should be lower than previous years if the company doesn’t want to expand its payout ratio.

Conclusion

There’s no margin of safety in Coca-Cola and Pepsi’s prices today. However, both of their dividends are sustainable, although Pepsi’s dividend is safer because it has a lower payout ratio.

If you own these companies and care about capital preservation, you might want to take some chips off the table. If you only care about a safe, growing income, you can hold on.

It would be safer to buy Coca-Cola and Pepsi if they reach the price ranges of US$29-35 and US$70-85, respectively.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Kay Ng has no position in any stocks mentioned. The Motley Fool owns shares of Coca-Cola and PepsiCo.

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