The current economic climate illustrates why it is so important to incorporate a margin of safety into equity valuations. Over the past two years, the world has been through one of the most volatile economic periods in recent memory. The pandemic wreaked havoc on the global economy, causing a seemingly illogical stock bull market at the same time, and just as it looked as if the world was starting to get back to normal, Russia invaded Ukraine, sending global commodity markets into a tailspin.
Unfortunately, none of this could have been predicted. Some analysts might have expected the Coronavirus pandemic to spread beyond China in the early days, but the chances of predicting this and then successfully predicting that Russia would invade Ukraine when it did were slim to none.
That is the big problem with equity valuation - it is impossible to tell what is just around the corner. That’s why we have to use a conservative margin of safety in our analysis to make sure we are getting good value for our money in the long-term.
Extrapolating current trends indefinitely
Something it seems many investors have been guilty of recently is extrapolating current trends indefinitely into the future. And I’m not talking about individual investors here, I am referring to some of the largest and most successful hedge funds of all time, such as Tiger Global. This fund ended 2021 with more than $100 billion in assets under management. It can afford the most expensive tools and research services and the best analysts on the market. However, even this vast pool of resources was not enough to prevent the firm from slumping 50% this year as its tech bets turned sour.
I do not have access to the hedge fund’s research models, so I can’t say for certain that it did not incorporate a margin of safety into its analysis and was too optimistic in its projections. Nevertheless, the rest of the market was, which is why shares in these tech stocks have dropped so precipitously over the past couple of months. Either Tiger Global got caught up with the general market euphoria, or its models were genuinely too overoptimistic.
Of course, using a margin of safety will not help investors avoid all losses. Losses are just part of the investing process, and we have to be prepared to take losses if and when they emerge. However, the point of using a margin of safety and incorporating conservative growth projections into equity valuation models is to make us double-check our figures. The process also forces us to consider whether the price the market is demanding for an asset is acceptable or not.
Consider a range of outcomes
This is one of the reasons why successful value investors such as Seth Klarman (Trades, Portfolio) have recommended using a range of valuation targets when analyzing securities. The idea behind this principle is to use a range of targets that incorporate different outcomes, forcing investors to think about how different environments will impact equity valuations.
For example, one currently developing theme is retailers warning on profits due to excessive inventory and the resulting inventory markdowns. Some retailers had assumed that the increase in demand for goods such as furniture and gameing consoles seen during the beginning of the pandemic would last forever. The latest information suggests it has not. Investors should have incorporated this prospective development into their analysis. Investors should always ask if demand is sustainable, and if not, how that will impact the company’s growth.
This strategy is not particularly easy, that's why it is important to stay within one’s circle of competence. Investors should not be investing in the retail sector if they do not have experience in how companies manage inventories and sales throughout the year. Without this experience, it is easy to pencil in over-optimistic projections based on second and third-hand information. The more guesswork that goes into a valuation model, the more likely it is that the model will be incorrect.
