In an age when market volatility is the norm and high speed computerized trading dominates the daily volume, investors would be well advised to consider an investment principle that has served some of history’s most successful investors extremely well. And that is to buy only those stocks for which the upside is substantial and the downside risk is limited. I know, easier said than done.
But with volumes having been written on this timeless principle, and contemporary mega-investors, such as Warren Buffet, proving its validity and power every day, it’s a wonder that more investors haven’t fully embraced the “Margin of Safety.” The lineage of margin of safety followers is that of royalty in the investment world. The principle emerged in the works of investment scholar, Benjamin Graham, also known as “the father of value investing.” Indeed, Graham spends an entire chapter in "Intelligent Investor" on the concept. Margin of safety later became the central theme of investment guru Seth Klarman, in his 1991 book, "Margin of Safety: Risk Adverse Investing Strategies for the Thoughtful Investor." Klarman’s book is no longer in print, so thoughtful investors pay as much as $1,300 on Amazon.com for a collector's copy. Klarman manages the ultra-successful Baupost hedge fund which has achieved an astounding 20% annual return with only one negative year. The most famous of margin of safety followers is Warren Buffet, who calls margin of safety "the three most important words in all of investing." In that case, we better take the principle seriously.
As scholarly as Graham was, his basic principle was based on simple truths. He knew that a stock priced at $1 today could just as likely be valued at 50 cents as it could be valued at $1.50 in the future based upon the vicissitudes of Mr. Market. He also recognized that the current valuation of $1 could be off which means he would be subjecting himself to unnecessary risk. He concluded that, if he could buy a stock as a discount to its intrinsic value, he would limit his losses substantially. Although there was no guarantee that the stock’s price would increase, the discount provided the margin of safety he needed to ensure that his losses would be minimal.
If, for instance, you were able to determine that the intrinsic value of IBM’s stock is $185 which is close to its current share price, you would apply a margin of safety of, say, 30% for a target purchase price of approximately $130. In this example, you may feel IBM is overvalued at $192, and wouldn’t consider buying it above its margin of safety acquisition price of value of $132. Using this model, you might not be able to purchase IBM stock anytime in the foreseeable future. But, if for reasons other than a collapse of IBM’s earnings outlook, the stock price does decline to $130, you can buy it with confidence. It is critical to ensure that your investment thesis is intact before buying a stock that is trading within your margin of safety sweet spot. Is the competitive advantage intact? Are there any factors that can impair the future cash flows of the company? Has the economic moat been breached? These are all questions that investors must constantly ask themselves of any stock in their portfolio and on their watch lists.
Applying this methodology has proven to be the most reliable way to build long-term wealth though stock market investing.
So, why don’t more investors adapt this incredibly successful investment principle? The answer can possibly be attributed to two essential requirements that many investors aren’t able to fulfill. First, is the ability to measure a company’s intrinsic value and, therefore, be able to apply an appropriate margin of safety. The second is the amount of patience needed to strictly adhere to the principle. As to the first, Graham, Klarman and Buffet have all admitted that there is no single or accurate way to measure intrinsic value. As the principle has evolved and been applied throughout the years, it has become evident that determining a company’s intrinsic value is less than a scientific endeavor. And, followers of the principle are left to their own devices to determine what an acceptable margin of safety is.
Asset-based approaches that look at liquidation and replacement value have been addressed in a previous article that we posted here. Briefly, Benjamin Graham, who is regarded as the father of value investing, established the NCAV strategy to find deep values. Dubbed as the "Net Current Asset Value" or "Net-Nets’ methodology, NCAV is calculated by subtracting all liabilities from the current assets on a per share basis. Graham looked for companies with market valuations approximately 66% of the net-net value. He gave himself at least a 33% a margin of safety to fall back on. Graham employed this methodology with a solid understanding of the company’s balance sheet and financial health.
Another method is determining what a knowledgeable industry player would pay for an entire company and brings in the concept of acquisition valuation. NYU’s Professor Aswath Damorandan laid out the following five steps with respect to acquisition valuation.
Step 1: Establish a motive for the acquisition.
Step 2: Choose a target.
Step 3: Value the target with the acquisition motive built in.
Step 4: Decide on the mode of payment — cash or stock, and if cash, arrange for financing — debt or equity.
Step 5: Choose the accounting method for the merger/acquisition — purchase or pooling.
Serious value investors should check out Professor Damorandan’s site here and should consider his scholarly work, "Damodaran on Valuation: Security Analysis for Investment and Corporate Finance," which can be purchased at Amazon.
Finally, there is DCF-based valuation. Warren Buffet stated that the fair market value of a stock can be calculated by calculating the future cash flow of the company and discounting it to the present. Calculating the intrinsic value can pose a challenge since there are different methodologies to value a stock and one can come up with entirely different conclusions regarding the intrinsic value of the company based upon different assumptions in their Discounted Cash Flow (DCF) model. We wrote about the strengths and weaknesses of DCF here (http://www.gurufocus.com/news/145102/the-strengths-and-weaknesses-of-dcf).
The next component is patience and temperament. To borrow very loosely from an analogy Buffett used, it’s as if you are a batter at the plate with an unlimited number of strikes. You can pass on any pitch that isn’t absolutely in the strike zone. And, in fact, you could wait on any pitch that isn’t right in your sweet spot. But, most investors aren’t able to wait for that perfect pitch. And, on the other end, many investors are unable to let go of a holding after it has run its course, that is, when its market price begins to exceed its underlying value.
The practical application of the margin of safety
The simplest way for value investors to apply the principle is to do the following:
1. Identify wonderful companies that you would like to own at a fair price.
2. Keep these companies on your watch list. Obviously, a diversified yet concentrated portfolio of these wonderful stocks is recommended for retail investors who cannot spend the time required to actively follow 40-50 stocks.
3. Determine the intrinsic value of the company and stay up to date on the company to ensure that your investment thesis and underlying valuation are intact.
4. Determine your margin of safety. While we have seen many anecdotes as to what the margin of safety should be, the truth is that it will depend on the underlying strengths of the company and predictability of operational performance. We cited Benjamin Graham’s 33% margin of safety that he applied to the NCAV strategy. Other anecdotes of Buffett’s margin of safety vary but based upon the preponderance of evidence, Buffett has acquired stocks at insanely deep discounts to intrinsic value (50-80% margin of safety for WPO in the early-mid 1970s) to a “wonderful company at fair price” approach that applies an approximately 20% margin of safety — a pretty wide range. We tend to have a 30-50% margin of safety.
5. Determine the capital that you can allocate to your stock purchases.
6. Set limit orders to buy the stock of interest and scale in at 5-10% increments, again, always keeping in mind the underlying investment thesis and valuation.
Here are three quick examples of this strategy in action and how it impacted our investment performance. Let’s start with our worst performer to date:
General Electric (NYSE:GE): We bought GE in July 2008 at approximately $27, believing the intrinsic value to be approximately $36. As the financial crisis hit the company on a variety of fronts, we recognized that the fundamentals had changed and that our analysis was flawed. The FMV estimate, derived from sum of the parts analysis, was reduced to approximately $25 (which we still believe today). Since then, we've looked to acquire in the $14-15 range (and 3.7-4% yield range). Based upon the last acquisition at $14.80, GE now represents 6.7% of the portfolio.
Accounting for dividend reinvestments, we have yielded an annual return of approximately 0% over the last theee years and five months. This performance is nothing to write home about but if you don’t look at your failures with a critical eye, you will never learn from them. We acknowledged that our intrinsic value calculation was off by nearly 50%, but the durable competitive advantage remained intact and we patiently stuck with the stock and bought additional shares at a discount. Our approach contrasts with selling out at a 50% loss which many panicked investors did at the time.
Apollo Group (NASDAQ:APOL): Like GE, we needed to adjust our intrinsic value calculation to account for the tsunami of government regulations that have pounded this sector after we made our first acquisition. We always bought below our current IV value of $59. Over the past 18 months, we have scaled into Apollo at $45, and then “backed the truck up” at $35. We have recently sold out at $49-$50 and made a nice profit, and have recently bought into a competing company, Strayer Education (STRA), which we believe to be a more compelling investment at this point. Click here for our recent comparison of APOL versus STRA.
Schering-Plough (formerly SGP, now MRK): In 2008, we did a painstaking sum of the parts valuation of SGP, valuing all commercialized pharmaceutical products, the drug pipeline, and the other operating segments to derive an intrinsic valuation of $28. With the stock trading near $14, we committed nearly 15% of our portfolio to acquiring the shares. Within six months, it was announced that Merck had (apparently) arrived at a similar intrinsic value calculation and a deal was structured for Merck to acquire Schering-Plough under the following terms:
(1) $10.50 in cash
(2) 0.5767 of a share of new Merck common stock.
We nearly doubled out money in six months and still have held onto 50% of the undervalued, high-yielding shares (4%+ dividend yield) of MRK that we got as part of the deal.
These are but three examples of how we applied patience and the margin of safety concept. We have some losses and we have some wins. Luckily, our wins have exceeded our losses and the strategy has led to outperformance of the S&P 500.
As Seth Klarman has stated so often, both in his book and his client newsletters, true value investors need to be over-weighed in patience. Investors like Buffet and Klarman would just as soon sit on a pile of cash than invest in something without the requisite margin of safety. They would rather deploy patience and wait for stock prices to come to them. If that sounds too simplistic it’s because it is.
About the author:
We apply Buffett's and Charlie Munger's four filters in selecting stocks as part of a concentrated portfolio (10-15 equities). Criteria for selecting companies are:
1.They are strong businesses; as defined by high long-term cash generation, above-average return on invested capital, possession of favorable underlying economics and a durable ...More competitive advantage, good financial health, and above-average profit margins
2. We understand the business
3. They are run by competent management
4. They are available at bargain prices.
We require a 25-50% margin of safety, depending on the stability and economic moat for the company.
In addition to equity research services, we are a member of the Gerson Lehman Group Expert Counsel of Advisors and provide research/consulting services to investment banks.