Friday, 20 January 2012

Margin of Safety Concept in Bonds and Preferred Stocks (Fixed Value Investments)

In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, “This too will pass.”  Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY. This is the thread that runs through all the preceding discussion of investment policy—often explicitly, sometimes in a less direct fashion. Let us try now, briefly, to trace that idea in a connected argument.

All experienced investors recognize that the margin-of-safety concept is essential to the choice of sound bonds and preferred stocks. 

For example, a railroad should have earned its total fixed charges better than five times (before income tax), taking a period of years, for its bonds to qualify as investment-grade issues. 
  • This past ability to earn in excess of interest requirements constitutes the margin of safety that is counted on to protect the investor against loss or discomfiture in the event of some future decline in net income. 
  • (The margin above charges may be stated in other ways — for example, in the percentage by which revenues or profits may decline before the balance after interest disappears—but the underlying idea remains the same.)
  • The bond investor does not expect future average earnings to work out the same as in the past; if he were sure of that, the margin demanded might be small. 
  • Nor does he rely to any controlling extent on his judgment as to whether future earnings will be materially better or poorer than in the past, if he did that, he would have to measure his margin in terms of a carefully projected income account, instead of emphasizing the margin shown in the past record. 
  • Here the function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future. 
  • If the margin is a large one, then it is enough to assume that future earnings will not fall far below those of the past in order for an investor to feel sufficiently protected against the vicissitudes of time.

The margin of safety for bonds may be calculated, alternatively, by comparing the total value of the enterprise with the amount of debt. (A similar calculation may be made for a preferred-stock issue.) 
  • If the business owes $10 million and is fairly worth $30 million, there is room for a shrinkage of two-thirds in value—at least theoretically—before the bondholders will suffer loss. 
  • The amount of this extra value, or “cushion,” above the debt may be approximated by using the average market price of the junior stock issues over a period of years. 
  • Since average stock prices are generally related to average earning power, the margin of “enterprise value over debt and the margin of earnings over charges will in most cases yield similar results.

So much for the margin-of-safety concept as applied to “fixed value investments.” Can it be carried over into the field of common stocks? Yes, but with some necessary modifications.

Ref:  The Intelligent Investor by Benjamin Graham

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