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

Also read:

• Margin of Safety Concept in The Business Venture of Buying and Selling Stocks
• Margin of Safety Concept in Conventional and Unconventional Investments
• Margin of Safety Concept in Speculation and Investment
• Margin of Safety Concept in Diversification
• Margin of Safety Concept in Undervalued or Bargain Stockss
• Margin of Safety Concept in Growth Stocks
• Margin of Safety in Good-Quality and Low-Quality Stocks.
• Margin of Safety Concept in Common Stocks
• Margin of Safety Concept in Bonds and Preferred Stocks

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

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




Also read:

• Margin of Safety Concept in The Business Venture of Buying and Selling Stocks
• Margin of Safety Concept in Conventional and Unconventional Investments
• Margin of Safety Concept in Speculation and Investment
• Margin of Safety Concept in Diversification
• Margin of Safety Concept in Undervalued or Bargain Stockss
• Margin of Safety Concept in Growth Stocks
• Margin of Safety in Good-Quality and Low-Quality Stocks.
• Margin of Safety Concept in Common Stocks
• Margin of Safety Concept in Bonds and Preferred Stocks
• 
  

Warren Buffett on investing in a climate of fear

Warren Buffett on investing in a climate of fear 

– a Q1 letter to send clients

April 12, 2010

"I have no idea what the stock market will do next month or six months from now. I do know that, over a period of time, the American economy will do very well and investors who own a piece of it will do well."

Warren Buffet in an interview on CNBC on Friday, October 10, 2008

After the market roller coaster of 2008 and 2009, the first quarter of 2010 has been blessedly uneventful by comparison. The US markets gained about 5% in the first quarter, the best start to the year since 1998 - the US market ended up about 60% from its lows of a year ago. Canada did well also, up almost  3% in the first quarter.

That said, there is still a cloud of uncertainty that is making many investors nervous.

Causes for concern ... and for optimism

Even with the stabilization of the global economy, there's no shortage of short term causes of concern:

... continued questions on the direction and timing of the economic recovery in the United States and Europe and the timing of higher interest rates

... US housing prices that are staying stubbornly low and unemployment levels in North America and Europe that are stubbornly high.

... and in late March the deputy director of the International Monetary Fund made headlines as he talked about the need for advanced economies to cut spending in order to reduce deficits. 

Here's a New York Times article about the IMF's views: http://www.nytimes.com/2010/03/22/business/global/22imf.html?scp=1&sq=lipsky%20imf&st=cse

The good news is that there are offsetting positives, even if the media headlines that feature them aren't quite as prominent:

... on Monday March 22, the Wall Street Journal ran a story about dividend hikes as a result of rising profits by US companies. The article also mentioned that cash on hand on US corporate balance sheets was at the highest level since 2007.

... on the same day the Financial Times ran a similar story about dividend increases in Europe

... and there's growing attention to the impact that Germany's emphasis on manufacturing productivity had in sheltering it from the worst of the economic downturn - and questions about whether  this might be a model for other countries. In March the Economist ran a 14 page feature on how Germany positioned itself for success.

Forecasting the future

Whether you choose to focus on the positives or the negatives, there's broad agreement that the steps taken by governments stabilized the financial crisis that we were facing a year ago - and there is almost no talk today of a global depression.

So the issue is not whether the economy will recover, but when and at what rate -and whether there might be another stumble along the way.

If you look for investing advice in the newspaper or on television, the discussion tends to revolve around what stocks will do well in the immediate period ahead ... this week, this month, this quarter.

We refuse to participate in that speculation - when it comes to short-term predictions, whether about the economy or the stock market, there's one thing we can say with virtual certainty: Most of them will be wrong.  Quite simply, no one has a consistent track record of successfully forecasting short term movements in the economy and markets.

Which is why in uncertain times such as today, one of the people I look to for guidance is Warren Buffett.

Advice from Warren Buffett

In an investment industry poll a couple of years ago, Warren Buffett was voted the greatest investor of all time; among the runners up were Peter Lynch, John Templeton and George Soros.

Buffett's returns are a testimony to the power of compounding.  From 1965 to the end of 2009, the growth in book value of his investments averaged 20% annually. As a result, $10,000 invested in 1965 would currently be worth a remarkable $40 million. By contrast, that same $10,000 invested in the US stock market as a whole, returning just over 9% during this period, would be worth $540,000.

In one of his annual letters to shareholders, Warren Buffett wrote that it only takes two things to invest successfully - having a sound plan and sticking to it. He went on to say that of these two, it's the "sticking to it" part that investors struggle with the most. The quote at the top of the letter, made at the height of the financial crisis, speaks to Buffett's discipline on this issue.

I try to apply that approach as well - putting a plan in place for each client that will meet their long term needs and modifying it as circumstances warrant, without walking away from the plan itself.

Boom times such as we saw in the late 90's and scary conditions such as we've seen in the past two years can make that difficult - but those conditions can also represent opportunity. Indeed, in his most recent letter to shareholders Buffett wrote that "a climate of fear is an investor's best friend."

Five core principles that shape our approach

On balance, I share Warren Buffett's mid term positive outlook, not least because many of the positives that drove market optimism two years ago are still in place, among these the continued emergence of a global middle class in developing countries like Brazil, China, India and Turkey. This educated middle class will fuel global growth that will make us all better off.

In the meantime, here are five fundamental principles that we look for in money managers and that  drive the portfolios that we believe will serve clients well in the period ahead.

1.     Concentrate on quality                                          

 The record bounce in stock prices over the past year was led by companies with the weakest credit ratings. Some have referred to last year as a "junk rally", with the lowest quality companies doing the best.  That's unlikely to continue- that's why I'm focusing my portfolios on only the highest quality companies, those best able to withstand the inevitable ups and downs in the economy.

2.     Look to dividends

Historically, dividends made up 40% of the total returns of investing in stocks and have also helped provide stability through market turbulence. Two years ago, quality companies paying good dividends were hard to find - one piece of good news is that today it's possible to build a portfolio of good quality companies paying dividends of 3% and above.

3.     Focus on valuations

Having a strong price discipline on buying and selling stocks is paramount to success - history shows that the key to a successful investment is ensuring that the purchase price is a fair one. Investors who bought market leaders Cisco Systems, Intel and Microsoft ten years ago are still down down 40% to 70%, not because these aren't great companies but because the price paid was too high.

4.     Build in a buffer

 Given that we have to expect continued volatility, we identify cash flow needs for the next three years for every client and ensure these are set aside in safe investments. That buffer protects clients from short term volatility and reduces stress along the way.

5.     Stick to your plan

In the face of economic and market uncertainty, another  key to success is having a diversified plan appropriate to your risk tolerance - and then sticking to it. It can be hard to ignore the short-term distractions, but ultimately that's the only way to achieve your long term goals with a manageable amount of stress along the way.

In closing, let me express my thanks for the continued opportunity to work together.  Should you ever have any questions or if there's anything you'd like to talk about, my team and I are always pleased to take your call.

Name of advisor

P.S. If you're interested, here's a link to Warren Buffett's 2010 letter to investors:                       http://www.berkshirehathaway.com/letters/2009ltr.pdf

http://clientinsights.ca/article/warren-buffett-on-investing-in-a-climate-of-fear-a-q1-letter-to-send-clients

A Q1 letter to send clients - Warren Buffett on investing in a climate of fear 

An important note:

Over the past 18 months, the quarterly templates for a client letter have ranked among the most popular features on this site.

Research with investors has identified the five elements of an effective client letter. It has to be:

1.     balanced in outlook

2.      candid

3.     short enough for clients to get through comfortably but long enough to be substantial

4.      supported by facts

5.     indicative of the advisors voice and personality

On this last point, if you like the basic structure of the letter, you MUST take the time to customize it to your own philosophy and outlook - I can't emphasize this strongly enough.