The Importance of Margin Of Safety

Given the current market conditions in which the likes of Robinhood have helped turn the stock market into a casino, I find it to be invaluable to re-read The Intelligent Investor by Benjamin Graham. I highly recommend Chapter 20 which covers the importance of margin of safety.

Chief Hazard Of A Buyer Of Securities

The risk of paying too high a price for good-quality stocks is a real hazard but is not the chief risk. The average buyer of securities encounters far greater risk from the purchase
of low-quality securities at times of favourable business conditions.

This is why I often mention that my focus is to invest in undervalued/fairly valued high-quality companies. You CAN make a lot of money without having to take unnecessary risks!

Not everyone investing in equities treats the stock market like a casino. Many investors look at a company's financial results to gauge how a company will perform in the future. The challenge, however, is to determine if a company's 'current good earnings' is synonymous with its safety. Quite often, companies sell at prices far above the tangible investment on the strength of excellent growth over the short term.

To see if an investment offers an adequate margin of safety, it is important to look at:

  • Free Cash Flow (FCF);
  • interest coverage; and
  • preferred share dividend coverage

over a period of several years. Of greater importance is to look at a company's performance during a difficult business environment (eg. The Financial Crisis).

Typically, inferior quality companies acquired at reasonable prices are likely to suffer when business conditions cloud over. While inferior businesses can recover on an eventual recovery in business conditions, it is unwise for investors to be confident of such a recovery. This is because there is an insufficient margin of safety to tide the investor through periods of adversity.

The Risk Of A High Valuation

The danger of investing in growth stocks that are 'market darlings' is that the market tends to set prices that are unlikely to offer adequate protection. The basic rule of prudent investing is that estimates when they differ from past performance must err slightly on the side of understatement.

Oftentimes, investors diversify to reduce risk. The benefits of diversification, however, may not work out satisfactorily if investments in multiple companies are acquired when they are all overvalued.

Just ask investors who invested in several grossly overvalued tech companies during the .com bubble in 1999. Diversifying through the purchase of shares in Intel, Cisco, JDS Uniphase, Worldcom, Tyco, Commerce One, etc. offered investors no margin of safety. Several 'high flyers' completely imploded and are no longer in business. The price of others, such as Intel and Cisco, are far lower even though more than two decades have elapsed; investment returns in companies like Intel and Cisco are worse when we account for the time value of money!

How I Look At A Company's Valuation

There are various ways in which to determine a reasonable price at which to acquire shares. Some investors use complex formulas and assumptions about projected earnings several years into the future. In fact, some investors plug data 10 years into the future in their formulas!

I can make reasonable estimates as to what a company may generate 1 - 2 years into the future. Plugging earnings estimates 10 years into the future into a formula, however, strikes me as nonsensical. How can any investor know what will occur that far into the future? People who use these formulas and can consistently accurately predict earnings that far into the future should be in the top 0.1% of the wealthiest people in the world. Clearly, this is not the case.

Stuff happens that we can not foresee which changes the data used in these complex formulas. This impacts the formula output.

  • Companies acquire other companies.
  • Companies divest segments of their business.
  • New competitors enter the market.
  • Interest rates change.
  • Rapidly changing technology can quickly make some products or services obsolete.
  • Significant unpredictable events occur (eg. covid, wars, trade wars, environmental disasters)

This is why I focus primarily on a company's:

  • credit ratings;
  • Free Cash Flow (FCF);
  • current earnings and short-term earnings guidance provided by management; and
  • adjusted earnings estimates from multiple brokers.

Naturally, it is important to analyze and compare a company's historical financial statements and accompanying notes to current results and guidance.

A company, for example, can improve its FCF if it drops its CAPEX to ~$0.1B, versus historical annual levels of ~$0.5B - $0.75B. FCF will look great but postponing mandatory CAPEX over a prolonged period can lead to inefficiencies and a loss of competitive advantages.

This is why it is so important to read the financial statements before making investment decisions. Merely looking at stock charts does not tell an investor what is happening with a company.

Money Can Be Made From Investments In Inferior Companies

Becton Dickinson - Case Study

Most investors would be wise to stick with investments in high-quality companies. I, for example, use Moody's, S&P Global, and Fitch's investment rating services when analyzing a company. My risk tolerance is low so I purposely choose to invest in investment-grade rated companies. On a very rare occasion, I invest in a non-investment grade company. I only do so if I am confident the company has a high probability of restoring its credit ratings to investment grade within a reasonable timeframe.

An example of this is my investment in Becton Dickinson (BDX). I initiated a position in February 2009 at which time Moody's and S&P Global rated the company's senior domestic unsecured debt the middle tier of the upper-medium investment-grade category. This rating defines an obligor as having a STRONG capacity to meet its financial commitments. It is, however, somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligors in higher-rated categories.

In March 2015, BDX acquired Carefusion and in December 2017 it acquired C.R. Bard. BDX's senior domestic unsecured debt experienced a few downgrades and was rated as low as the top tier of the non-investment grade category. Its ratings placed it in a position where it was viewed as being LESS VULNERABLE in the near term than other lower-rated obligors. However, it faced major ongoing uncertainties and exposure to adverse business, financial, or economic conditions which could lead to the obligor's inadequate capacity to meet its financial commitments.

When these acquisitions were made, management communicated to the investment community its game plan to restore its rating to investment grade. I was confident this was achievable in the timeframe set out and on several occasions I acquired additional BDX shares; in my mid-April review of all my holdings, we see that BDX is my 5th largest holding.

Fast forward to the present and Moody's now rates BDX's senior domestic unsecured debt at the lowest investment grade tier and S&P Global rates it at the 2nd lowest investment-grade tier. Management has also indicated the plan is to improve upon the current ratings.

Make RISK A Good 4 Letter Word

Brookfield Asset Management and Oaktree Capital

Money can certainly be made from investments in inferior quality companies. The challenge, however, is that success with such investments requires unique resources and a great deal of expertise. I do not have the requirements to be successful when it comes to investing in inferior quality companies.

This type of investing requires a keen sense of being able to ask, amongst other things, what are:

  • the key risks;
  • the probabilities of these key risks occurring;
  • the probabilities of revitalizing the company so it is no longer in distress;
  • reasonable values of the assets in a liquidation scenario.

The skills required to invest is such companies is very different from those required to evaluate a high-quality company. I certainly do not think an investor should look at Hertz (HTZGQ) the way one would look at Visa (V) or Mastercard (MA).

Since I do not have what it takes to invest in inferior quality companies but know money can be made such investments, I invest in Brookfield Asset Management (BAM-a.TO); this is my 11th largest holding.

In September 2019, BAM acquired a ~61.2% stake in Oaktree Capital Management. Oaktree is a leader among global investment managers specializing in alternative investments. The firm emphasizes an opportunistic, value-oriented and risk-controlled approach to investments in credit, private equity, real assets and listed equities.

When Brookfield acquired Oaktree I wanted to learn more about Howard Marks, co-founder and co-chairman of Oaktree, and his firm so I periodically read his Memos found on Oaktree's website.

I also periodically read chapters in my copies of:

The Mastering the Market Cycle - Getting the Odds on Your Side

and

The Most Important Thing Illuminated - Uncommon Sense for the Thoughtful Investor

Berkshire Hathaway

If you are looking to make RISK a good 4 letter word look no further than Berkshire Hathaway (BRK-a and BRK-b); this is my 6th largest holding. If any group of people knows something about the importance of a margin of safety, it is the team of Buffett, Munger, Ajit Jain (Vice-Chairman - Insurance Operations), and Gregory Abel (Vice-Chairman - Non-Insurance Operations). They eat, sleep, and breathe 'margin of safety'.

Their ability to evaluate risk is exceptionally important since BRK is in the insurance and reinsurance businesses; just over 51,000 employees are in operating companies that fall within this group (refer to section A at the back of the 2020 Annual Report).

The Importance Of Margin Of Safety - Final Thoughts

Coincidentally, BRK's 2021 Annual General Meeting was May 1, 2021. This year's AGM can be viewed here. Buffett, Munger, Jain, and Abel cover a variety of topics of which two are risk and the rampant speculation by unsophisticated investors.

I very highly recommend anybody interested in learning about investing and, in particular, about the importance of a margin of safety listen to the Q&A session.

The Q&A session is ~4 hours 45 minutes in length so I suggest using the settings icon at the bottom right-hand corner of the YouTube video to increase the playback speed.

Stay safe. Stay focused.

I wish you much success on your journey to financial freedom!

Note: Please send any feedback, corrections, or questions to [email protected].

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Disclaimer: I do not know your circumstances and am not providing individualized advice or recommendations. You should not make any investment decision without conducting your research and due diligence.

I wrote this article myself and it expresses my own opinions. I do not receive compensation for it and have no business relationship with the company mentioned in this article.