Margin of Safety

Hey guys!

I'd like to take the chance to talk to you about a pivotal concept to value investing known as the margin of safety.  This is a key factor that needs to be considered by any investor that wants to survive in the markets.  The margin of safety; simply put, is what will save your investment during difficult times.  If all investments turned out exactly as we expected, we would not need a margin of safety--there would be nothing we would need to be kept safe against!  Yet unfortunately this is not the case.

Let us look at what a margin of safety is:  First for a company, then for an investor.

Suppose we are examining a company that has a 50% chance to make $1 million and a 50% chance to lose $1 million.  This is extremely simplified, but it is not unlike many of the circumstances investors face in reality. Companies need to meet or exceed their fixed and financing costs, otherwise they lose money.  And many companies do lose money; or have lost money in the past.  It is not inconceivable that a company you may invest in might lose money at some point in the future!

So in our very simple company, what is the margin of safety here?  Well, the first layer of this margin of safety is excess cash.  It is a very good thing for a company to keep some around to meet their obligations.  But, almost as good are things like short term receivables and inventory.  Please note that I say almost as good.  There is a common scam that companies pull that involves booking phantom transactions to accounts receivable to increase their income.  Always be conscious of accounts receivable that grow at a faster rate than sales, it is a cause for alarm.  However, in a normally functioning, honorable company, accounts receivable and inventory should be converted into cash in fairly short notice, surely enough time to meet obligations.

Often times, rookie investors will put too much emphasis on growth in earnings and not examine the balance sheet of the company they invest in.  You can't trust the book value of their fixed assets, that is for sure, but cash is cash and current assets should be reasonably accurate when determining what protection this company has.

Often times, value investors invest in firms that have suffered financially.  There is usually a speciously compelling reason for why a stock trades at a discount to its intrinsic value.  Determining the margin of safety, and where it is for the firm you intend to invest in is a crucial point in value investing.  How much worse do things have to get for your firm to file for bankruptcy?  How long could the company run on its current assets?

For the value investor, there is a second level to the margin of safety, which has to do with the pricing of the security.  We demand that our firms have a margin of safety like that illustrated above, but we also demand that we can acquire our firms for a low enough price to make it incredibly unlikely that we will lose money.  Let us look at a typically Grahamian investment.

Anyco. Insurance
Cash $20m
Other Current Assets $40m
Long Term Assets: $60m
Liabilities: -$10m

Share Price: $3, Shares Outstanding: 15m.

Take a look and see if you can see why, even without knowing anything about this company's income or expenses, this may be an attractive investment target.  If there are 15 million shares outstanding and the share price is $3, this means that we can purchase the firm for $45m.  $20 million of that is already in cash.  If we bought the firm outright, we could dividend ourselves back $20m, which means we're only risking $25m on the rest.  If all goes well, we can convert the other current assets to cash, which we could then dividend off again.  After that, we would be taking no risk at all- we have paid out $60m to ourselves after we had invested only $45m.  Take that and throw in the whole rest of the company for free!

Two points before I wrap up:  First, if we had bought the company for $500m because we were anticipating large growth in earnings and that growth did not materialize, where would we be?  In the first case where we pay so much less, even if the firm has meager or anemic growth, we got the business for free so any profitability would simply be a bonus.  In the case where we pay $500m, we may find ourselves stuck with a firm that another investor is not interesting in paying such a hefty premium on.  Growth investing can be hazardous to your health!

Second point:  You may be thinking right now, "but I can't afford to buy a whole business and dividend to myself money!" Yes, sure, not yet at least, but let me assure you that other companies are spending time scouring for just these such deals.  If you are holding these extra-valuable shares when another company comes looking to do precisely that, they will cause the share price to jump considerably with an acquisition offer.  This is the hidden bonus to many value investor investments--sometimes people ask, "why don't you go for the quick buck in the markets?"  Well, truthfully, we value investors do like a quick buck; we just don't rely on gimmicks to get there.  But when a company comes along and offers to buy out a firm that you hold, they often do so with a hefty premium to the current market price to convince all the shareholders to go ahead with it.  This has happened to me more than once and it is a wonderful piece of news to wake up to in the morning, let me tell you!

More value investing to come next week.