However, investors need to be as focused as ever to find stocks that will not just do well when the market goes up, but also have the capacity to protect investors against the inevitable next market downturn. This is called a margin of safety, which some stocks simply don’t offer in the current market environment.
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 that lack meaningful margins of safety, which investors would be wise to keep an eye on going forward.
Modest growth, with valuations that are anything but modest
These companies’ underlying financial performance, while solid, is more indicative of mature value stocks than of growth stocks deserving of lofty valuations. For example, McKesson Corporation (NYSE:MCK) is a $26 billion health care giant with an equally impressive valuation profile.
There’s no doubt that the company is financially successful and highly profitable. To that end, McKesson Corporation (NYSE:MCK) booked $122 billion in revenue last year. While impressive, the company saw no growth in 2012 revenue year-over-year. Ditto for profitability— McKesson Corporation (NYSE:MCK) earned $5.59 in diluted EPS last year, flat versus 2011.
That hasn’t stopped McKesson Corporation (NYSE:MCK)’s stock price from rallying. The stock has returned more than 20% just since the beginning of this year. As a result, McKesson now trades for 21 times earnings and provides a paltry dividend yield of just 0.8% annualized.
Ditto for a different health-care stock, Stryker Corporation (NYSE:SYK), which holds a $25 billion market cap, comparable to McKesson Corporation (NYSE:MCK).
Stryker Corporation (NYSE:SYK) exchanges hands for nearly 21 times trailing earnings, despite full-year 2012 results that were unspectacular. While Stryker did book 4% revenue growth, the company’s diluted earnings per share actually fell nearly 2%, largely the result of significantly higher expenses.
There wasn’t a whole lot to brag about in the company’s first-quarter report, either. Net sales inched up 1% and diluted earnings per share grew by just 4% year over year. Yet Stryker Corporation (NYSE:SYK)’s stock price has surged anyway, rising 22% to begin 2013.
Stryker did provide investors with a 24% dividend increase last year, but even so, the stock yields just 1.5% at recent prices.
Too spicy for my taste
Spice and seasoning kingpin McCormick & Company, Incorporated (NYSE:MKC) is a darling among the dividend community. Indeed, the company has an enviable streak of paying dividends to shareholders for 89 years in a row, and investors were treated to a 10% dividend increase this year.
However, the stock price has rallied so much that the stock no longer offers a compelling yield. McCormick & Company, Incorporated (NYSE:MKC) yields just 1.8%, less than the approximately 2% yield available on the S&P 500 Index.
Moreover, the company trades for 24 times trailing earnings, a lofty valuation when you consider that its recent operating results left a lot to be desired. McCormick & Company, Incorporated (NYSE:MKC) reported 8% growth in 2012 net sales and earnings per share. That was followed up by just 3% growth in net sales and earnings per share in the first quarter, year-over-year.
The Foolish bottom line
Paying too high a price for a company’s earnings is one of the surest ways to under-perform the market over time. Value investors understand the merits of purchasing stocks trading at attractive enough prices that they offer shareholders a meaningful margin of safety through downside protection and dividend income. This means that when the next downturn arises, such a stock won’t get crushed as badly. While it might not seem like a useful endeavor today, it pays off when the market goes down—and rest assured, there will be another market downturn sooner or later.
Investors who would like to buy these stocks would do themselves a service by exercising patience here. These are high-quality, profitable businesses, but it needs to be said that the stocks trade for uncomfortably high valuations and offer little in the form of dividend yield cushions. 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.
The article Resist Stocks With No Margin of Safety originally appeared on Fool.com and is written by Robert Ciura.
Robert Ciura has no position in any stocks mentioned. The Motley Fool recommends McCormick and McKesson. Robert is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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