Warren Buffett went on to build one of the greatest fortunes in history after studying under Benjamin Graham at Columbia University.
One thing Buffett learned there was to always ensure that a margin of safety exists in any stock you might buy. A margin of safety to Graham meant that there was a likelihood of profit even if the stock was bought too soon and went down in price after the initial purchase.
To find that kind of "safe" value, Graham liked to see a long history of positive earnings and steady dividends.
Graham knew that the future was unpredictable, but he thought that looking at the past provided the best way to reduce uncertainty. If a company had alternated between gains and losses over the past few years, for instance, one might expect that trend to continue. Likewise, a string of positive earnings was more likely than not to be followed by more positive earnings.
One favorite of Graham's was utility stocks. He considered their high dividends to be a margin of safety. Even if he paid a little more than he would have liked, the dividend would offset any short-term losses.
In Graham’s words, “To have a true investment, there must be a true margin of safety. And a true margin of safety is one that can be demonstrated by figures … and by reference to a body of actual experience.”
Steady dividends, then, are based on experience and can provide comfort in the bad times that are unavoidable in the market.
For this week’s screen, we followed Graham’s counsel and searched for stocks with a margin of safety:
• Utilities are considered to be safe stocks since they have reliable, nearly recession-proof sources of revenue. People always need electricity or natural gas, and rates are often supported by government regulation.
• Earnings should be positive for each of the last seven years. Graham liked to ensure that the company had successfully weathered changing economic environments.
• Dividends should have been paid in each of those seven years; this demonstrates management’s commitment to shareholders.
• The dividend yield should be at least 4 percent, slightly more than the yield available on a risk-free, 10-year U.S. Treasury note.
• The annual dividend should be less than current annual earnings.
• The P/E ratio, using average earnings for the past three years, should be less than 25, which is the equivalent of an earnings yield equal to the interest rate of a 10-year U.S. Treasury note.
The eight stocks that passed our Ben Graham utility stock screen offer an average yield of 5 percent:
AGL Resources (ATG) Yielding 5.1 percent at a recent price of 34.03, ATG has been increasing its dividend at a rate of about 9 percent a year, in line with earnings growth.
Atmos Energy (ATO) At a recent price of 26.77, ATO is yielding 4.9 percent and selling at a price-to-sales ratio of 0.38, less than a third of the industry average. This indicates potential room for growth in the stock price as this ratio moves closer to that average.
Chesapeake Utilities (CPK) Priced near 25.50 recently and yielding 4.8 percent, CPK has an impressive list of large shareholders. James Simons’ Renaissance Technologies is among the largest. Simons has delivered returns averaging 35 percent a year to his shareholders since 1989.
Consolidated Edison (ED) This utility company has been serving customers since 1884 and currently provides electricity and natural gas to more than 3.2 million households, including more than a million in New York City. It has one of the highest yields in the industry, and the payout ratio is near the industry average. Recently priced at 39.09 and yielding 6.2 percent.
DTE Energy (DTE) With a P/E ratio of 8 at the recent price of 44.57, DTE seems to be discounting the economic woes of Michigan, where it serves over a million customers. Its yield of 4.9 percent is safely covered by slow-growing earnings.
Integrys Energy Group (TEG) Analysts expect earnings to grow by more than 20 percent this year before slowing to a sustainable 7 percent next year. At a recent price of 52.26, TEG yields 5.3 percent.
MGE Energy (MGEE) Recently trading at 33.13, MGEE offered investors a 4.4 percent yield. This small Wisconsin-based company has a return on equity of more than 15 percent, among the highest in this regulated industry.
OGE Energy (OGE) Analysts are looking for a potential total return of about 18 percent from this stock over the next 12 months. Its recent price of 31.74 provided a yield of 4.4 percent.
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