Friday, 20 January 2012

Margin of Safety Concept in Common Stocks

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.

There are instances where a common stock may be considered sound because it enjoys a margin of safety as large as that of a good bond. 

This will occur, for example, when a company has outstanding only common stock that under depression conditions is selling for less than the amount of bonds that could safely be issued against its property and earning power.# 
  • That was the position of a host of strongly financed industrial companies at the low price levels of 1932–33. In such instances the investor can obtain the margin of safety associated with a bond, plus all the chances of larger income and principal appreciation inherent in a common stock. 
  • (The only thing he lacks is the legal power to insist on dividend payments “or else”—but this is a small drawback as compared with his advantages.) 
  • Common stocks bought under such circumstances will supply an ideal, though infrequent, combination of safety and profit opportunity. 
  • As a quite recent example of this condition, let us mention once more National Presto Industries stock, which sold for a total enterprise value of $43 million in 1972. With its $16 millions of recent earnings before taxes the company could easily have supported this amount of bonds.

In the ordinary common stock, bought for investment under normal conditions, the margin of safety lies in an expected earning power considerably above the going rate for bonds. In former editions we elucidated this point with the following figures:
  • Assume in a typical case that the earning power is 9% on the price and that the bond rate is 4%; then the stock buyer will have an average annual margin of 5% accruing in his favor. 
  • Some of the excess is paid to him in the dividend rate; even though spent by him, it enters into his overall investment result. The undistributed balance is reinvested in the business for his account. 
  • In many cases such reinvested earnings fail to add commensurately to the earning power and value of his stock. (That is why the market has a stubborn habit of valuing earnings disbursed in dividends more generously than the portion retained in the business.)* 
  • But, if the picture is viewed as a whole, there is a reasonably close connection between the growth of corporate surpluses through reinvested earnings and the growth of corporate values.
  • Over a ten-year period the typical excess of stock earning power over bond interest may aggregate 50% of the price paid. 
  • This figure is sufficient to provide a very real margin of safety— which, under favorable conditions, will prevent or minimize a loss. 
  • If such a margin is present in each of a diversified list of twenty or more stocks, the probability of a favorable result under “fairly normal conditions” becomes very large. 
  • That is why the policy of investing in representative common stocks does not require high qualities of insight and foresight to work out successfully.

If the purchases are made at the average level of the market over a span of years, the prices paid should carry with them assurance of an adequate margin of safety. 

The danger to investors lies in concentrating their purchases in the upper levels of the market, or in buying nonrepresentative common stocks that carry more than average risk of diminished earning power.

  • As we see it, the whole problem of common-stock investment under 1972 conditions lies in the fact that “in a typical case” the earning power is now much less than 9% on the price paid.**
  • Let us assume that by concentrating somewhat on the low-multiplier issues among the large companies a defensive investor may now acquire equities at 12 times recent earnings—i.e., with an earnings return of 8.33% on cost. 
  • He may obtain a dividend yield of about 4%, and he will have 4.33% of his cost reinvested in the business for his account. 
  • On this basis, the excess of stock earning power over bond interest over a ten-year basis would still be too small to constitute an adequate margin of safety. 
  • For that reason we feel that there are real risks now even in a diversified list of sound common stocks. 
  • The risks may be fully offset by the profit possibilities of the list; and indeed the investor may have no choice but to incur them—for otherwise he may run an even greater risk of holding only fixed claims payable in steadily depreciating dollars. 
  • Nonetheless the investor would do well to recognize, and to accept as philosophically as he can, that the old package of good profit possibilities combined with small ultimate risk is no longer available to him.***

# “Earning power” is Graham’s term for a company’s potential profits or, as he puts it, the amount that a firm “might be expected to earn year after year if the business conditions prevailing during the period were to continue unchanged” (Security Analysis, 1934 ed., p. 354). Some of his lectures make it clear that Graham intended the term to cover periods of five years or more. You can crudely but conveniently approximate a company’s earning power per share by taking the inverse of its price/earnings ratio; a stock with a P/E ratio of 11 can be said to have earning power of 9% (or 1 divided by 11). Today “earning power” is often called “earnings yield.”

* This problem is discussed extensively in the commentary on Chapter 19.

** Graham elegantly summarized the discussion that follows in a lecture he gave in 1972: “The margin of safety is the difference between the percentage rate of the earnings on the stock at the price you pay for it and the rate of interest on bonds, and that margin of safety is the difference which would absorb unsatisfactory developments. At the time the 1965 edition of The 
Intelligent Investor was written the typical stock was selling at 11 times earnings, giving about 9% return as against 4% on bonds. In that case you had a margin of safety of over 100 per cent. Now [in 1972] there is no difference between the earnings rate on stocks and the interest rate on stocks, and I say there is no margin of safety . . . you have a negative margin of 

safety on stocks . . .” See “Benjamin Graham: Thoughts on Security Analysis” [transcript of lecture at the Northeast Missouri State University business school, March, 1972], Financial History, no. 42, March, 1991, p. 9.

*** This paragraph—which Graham wrote in early 1972—is an uncannily precise description of market conditions in early 2003. (For more detail, see the commentary on Chapter 3.)

Ref:  The Intelligent Investor by Benjamin Graham

CHAPTER 20 “Margin of Safety” as the Central Concept of Investment

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1 comment:

Sunil Dani said...

this is an excellent article which substantiates Benjamin Graham,s principle that the future gains will largely depend on what price an investor pays while purchasing the stock. This will also provide the vital margine of safety for his principal amount.