Margin of safety

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Margin of Safety as an Investment Philosophy

What any client needs to know is why a margin of safety approach is a robust strategy for combining safety of principal with satisfactory returns. Understand margin of safety and you possess the keys to the kingdom. Act on margin of safety and you have a financial plan to last a lifetime.

Margin of safety is bargain hunting on steroids. The strategy was pioneered by Benjamin Graham, the dean of value investing and the founder of modern security analysis. Margin of safety investing involves the systematic comparison of values and prices. Value is the sum of future profits earned by a company during its lifetime, discounted back to establish a present value. The margin of safety investor searches for gaps, ideally chasms, between this intrinsic value of a business and the extrinsic, fluctuating price of shares of that business. Price matters. The margin of safety investor tries to buy only when the company is selling at a substantial discount to the underlying value of the business. When the investor correctly identifies a discount, and when the market comes to properly value the business, the investment appreciates.

The spread between price and intrinsic worth achieves two very important things for the investor. First, buying at a discount preserves the principal. Getting substantially more value than one is paying for reduces the risk that the amount of value received will fall below invested capital.

Second, margin of safety maximizes reward consistent with the reduction of risk. Markets tend to eventually correct themselves and price stocks in a fair manner. When an investor purchases one dollar of intrinsic value for sixty cents, the rewards are terrific. As margin of safety increases—say, one dollar of value purchased for fifty cents—reduction of risk and enhancement of reward occur simultaneously There is no trade-off of risk and reward; quite the contrary.

A disciplined comparison of slow-to-change intrinsic values and fluctuating extrinsic prices keeps the focus on what matters. A valuation must be possible. When the uncertainties about the future of a business are too great, valuation is not feasible, and a margin of safety analysis cannot proceed. In these circumstances, the business should be excluded as a candidate for purchase. Valuation difficulties effectively eliminate most marketable securities from serious consideration.

Market timing and predicting market movements don’t play a role in a margin of safety portfolio. What matters is the disparity between the intrinsic value of a particular company and the current selling price. True value acts as a magnet upon the market, pulling the trading price toward a fair price. When a company is purchased at a discount, the pull is upward. The investor is rewarded as the market corrects itself. No one knows when the upward pull will begin or how long it will take. And while it is useful to look for catalysts that might unlock value, margin of safety requires patience.

A margin of safety analysis looks for value in the right places. How sustainable are a company’s earnings? What are the prospects for earnings growth over time? Well-run businesses that produce consistent (and compounding) high returns on invested capital can present outstanding opportunities, provided that the price is right.

Topping this list are companies with unique economic franchises that are difficult for others to replicate. Franchises possess key competitive advantages like strong customer loyalty and leadership in markets with high barriers to entry. Consequently franchises enjoy pricing power. Franchise companies also can also allocate more of their free cash flow to activities like sales and marketing that boost profits and relatively less to those required to maintain a business.

Even when companies lack franchise qualities, they can excel through keen attention to operations and costs controls, along with a passionate commitment to serving their customers. Companies with these qualities rack up consistently profitable results despite having to compete in very crowded industries like manufacturing, financial services, and retail.

Good companies (franchises and non-franchises) generate large amounts of free cash flow with strong underlying operating margins. They avoid unnecessary debt and build strong capital structures. These companies will retain their earnings when they can do something productive with that cash on behalf of shareholders. And when they cannot, a good company returns excess cash to its owners through stock repurchases or dividends or both.

Companies worth investing in have able, ethical managers. Good managers do their best to enhance shareholder value by thinking and acting like owners; and better yet, by owning shares themselves. They are truthful with their shareholders when difficulties arise. Good managers also hate to spend money unnecessarily. They keep costs down as a general policy, resist the temptation to build empires that are a drain on profits, and vigilantly watch the return on profits that are retained rather than returned to the shareholders.

Investment opportunities arise when some within the small group of companies possessing these attributes are selling at bargain prices.

When it comes to selling, striking the right balance is critical. A company with excellent long-term prospects tends to build shareholder value year after year, so there is a reluctance to sell simply because the market price has risen and now more fully reflects true value. Share prices of good businesses are likely to appreciate over time. Reinvested profits compound the value of a company free from the penalty of capital gains taxation. On the other hand selling makes sense when a company’s competitive advantages are eroding, or the initial buying decision proves to be wrong, or one identifies a superior opportunity.

Margin of safety is conservative, patient, and independent. It is not governed by the market. Rather it provides an incomparable method for identifying the genuine opportunities that the market on occasion presents. There are a number of managers who do it exceptionally well and they should be part of a client’s portfolio. For those who like being thoroughly prepared, and who want long term wealth appreciation rather than strike-it-rich speculation, margin of safety truly is an excellent choice. Please contact Palmerston.