By Hugo Roque of www.vforvalue.blogspot.com
“Confronted with the challenge to distill the secret of sound investment into three words, I venture the motto: Margin of Safety”
It is in Chapter 8 of “The Intelligent Investo” that Benjamin Graham, the father of value investing philosophy, describes the concept of Margin of Safety: any investor, bearing in mind the objective of capital preservation, should seek, in all its investments, a reasonable difference between the value it assigns to the business (intrinsic value) and the price it can be bought in order to protect himself in case some unfavorable event happens and to maximize the investment return if the analysis is confirmed. In the words of his disciple, Warren Buffett: “Never depend on a good sale. Get a purchase price so attractive that even a mediocre sale will produce good results.”
However, in the field of investments analysis and prospecting, the value investor can and should seek other sources of security for its investments, not only the demand of a discount to intrinsic value. Thus, the investor can: 1) select businesses with healthy balance sheets and the potential for value creation, 2) explore investment opportunities in periods of economic difficulties, 3) using conservative estimates that lead to greater comfort in the analysis and determination of intrinsic value. All these elements can contribute decisively to strengthening the robustness of the margin of safety.
Certain characteristics of businesses protect shareholders and position the company to create value in the long run. A low debt to equity ratio is one way to safeguard the business future against unforeseen events that could potentially jeopardize the company’s competitive position. Recessions, costly litigation or assets devaluation, can put a apparently balanced company in serious liquidity problems.
A very low debt ratio also gives the stock some value creation potential from leveraging the business. The emission of debt in amounts deemed conservative and without endangering the future of the company can be beneficial for business, in that there are tax gains can be obtained by the fact that the interest charges are considered costs, and those translate into tax savings.
The quality of the assets of a company’s balance sheet can be another source of investment security. The possession of valuable assets such as well located buildings or land, liquid assets like cash or deposits, of mostly tangible assets that are easily mensurable, contributes to greater certainty in assessing the value that shareholders have in the company’s balance sheet which combining with low debt, and taking into account the market price of those assets, may represent a safe investment opportunity.
Also the selection of business within the circule of competence of the investor can raise the confidence level of the firm’s valuation. Simple business structures, well defined, with clearly defined products and markets, consistent profit margins and visible growth prospects, facilitate the analysis.
A recession, a problem with a particular sector or a pontual trouble on a company can create the ideal climate for the detection of profitable investments. Cyclical circumstances that can have disastrous consequences in the markets and in the performance of the affected stocks, can create great investment opportunities if we focus on the value of those businesses over time. In hard times corporate profits fall, margins huddle and debts pile up. The financial ratios deteriorate and uncertainty about the future development of the business intensifies. However, we have seen it many times that the resulting adjustments in stock prices go far beyond the reasonable with markets many times overreacting to bad news. Thus it is created a comfortable margin of safety supported the expectation of a better future economic environment, the stabilization of industry conditions or the resolution of the company’s specific problems. These scenarios should be carefully considered, as well as operational and financial capacity of the company to overcome such difficulties.
When estimating the value of a business some estimates are needed regarding the future performance of the company. What will be the company’s earnings growth in coming years? The company will maintain its competitive position? Can it maintain or improve its profit margins? Will it require significant investments to maintain or expand the business? What discount rate (rate of return required by shareholders) should we use to discount expected cash flows? All these issues need to be answered, but the investment wil be better protected if they answered in a conservative way. Probably the calculated value for the business will be lower under these circumstances but on the other hand, it gives greater certainty and comfort.
All these factors contribute to the definition of a strong margin of safety, which will be the enduring basis for a successful policy of value investments.