Do These Stocks Provide a Margin of Safety?

Bob is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

When the stock market is doing very well, investors tend to lose sight of valuation. It’s important to not get caught up in the market’s performance and risk turning a blind eye to disciplined investing practices. One such concept that investors would be wise to keep in mind today is the margin of safety. Many value investors understand the need to buy stocks at prices meaningfully below their intrinsic values to simultaneously provide downside protection as well as maximize future return potential.

With the markets setting new historic highs, there now appears to be a glut of stocks that are trading for rich valuations. Some stocks will prove dissenters wrong by growing their sales and profits fast enough to justify their multiples, but in many instances, investors are being set up for disappointment. With that in mind, here are a few stocks with lofty valuations, which investors would be wise to keep an eye on going forward.

Popular businesses with well-known brands

Brown-Forman (NYSE: BF-B) is a giant in the alcohol business, with a stable of extremely popular brands including Jack Daniels and Southern Comfort. Brown-Forman has been in business for 140 years and operates in approximately 135 countries worldwide, and is a popular growth stock that has provided investors with big returns over the past several years. Those who purchased Brown-Forman stock exactly five years ago have seen their investment more than double, including reinvested dividends.

Another company whose products investors are likely familiar with is McCormick (NYSE: MKC) and its namesake spices, seasoning mixes, and condiments. The company was founded more than a century ago, and has made investors a lot of money along the way. In fact, shares are up more than 40% since the beginning of 2012, not even including dividends.

Hormel (NYSE: HRL) is another very-well known company which probably needs no introduction. The company was founded in 1891, and has since sold its flagship Spam and Hormel Chili. Hormel has taken steps to broaden its product portfolio over the years. The company holds the Jennie-O brand, and earlier this year announced the acquisition of the Skippy peanut butter line. Hormel has an outstanding track record of 47 consecutive years of dividend increases, but income investors are likely left wanting more than the stock’s current 1.6% yield.

Speaking of dividends, Brown-Forman has a strong track record of its own. The company has grown its shareholder payout every year for the past 29 years. The company raised its dividend 9% last year. However, due to the stock’s strong performance over the past few years, the dividend yield is now only 1.5%, below the roughly 2% yield available on the broader market.

Likewise, McCormick’s dividend yield also trails the yield available on the S&P 500 Index. The spice king yields less than 2%, even after raising its dividend by 10% late last year. McCormick has paid consecutive dividends to shareholders for 89 years in a row.

Value stocks with growth stock valuations

These companies’ underlying financial performance, while solid, is more indicative of mature value stocks than of growth stories. For example, Brown-Forman reported sales growth of 4% through the first nine months of the fiscal year, and also updated its full-year outlook. Brown-Forman expects earnings per share to be between $2.60 and $2.68 per share, meaning investors are currently paying more than 26 times this year’s earnings at the midpoint of the target range.

Meanwhile, McCormick reported growth in net sales and earnings per share of just 3% each in the first quarter, year-over-year. Also, the company reaffirmed its outlook for 2013 EPS to come in between $3.15 and $3.23, meaning the stock now trades for 23 times the midpoint of its forecast.

Finally, Hormel trades for 22 times its trailing twelve-month earnings per share. The company reported flat diluted earnings per share for the first quarter of the fiscal year, along with 4% revenue growth versus the first quarter of 2012. For the full year, the company expects EPS of between $1.93 and $2.03 per share, meaning new investors are paying more than 20 times forward earnings for the company.

Wait for a better price

With the Dow returning 11% in the first quarter despite the U.S. remaining in a slow-growth economic recovery, the markets may have gotten ahead of themselves a bit and investors would be wise to remember the core tenets of value investing.

Brown-Forman, McCormick, and Hormel are extremely well-run, profitable businesses whose products are likely found in many homes across the United States. They’ve each rewarded their investors with dividends, but even more so with huge capital gains over the past several years.

That being said, their operating performance is not becoming of stocks with P/E ratios in the mid-twenties. Investors who would like to buy these stocks would do themselves a service by exercising patience here. Buying opportunities generally present themselves sooner or later, and if you’re interested in these stocks, wait for a better price before pulling the trigger.

Robert Ciura has no position in any stocks mentioned. The Motley Fool recommends McCormick. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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