A Heuristic Formulation of the Margin of Safety

 |  Includes: AMAT, GM, GOOG, HPQ, LAZ, MO, MSFT
by: Sebastien Buttet

"The Intelligent Investor," one of my favorite books on investing written by Benjamin Graham, the father of value investing, and first published in 1949, is a classic that must be read by anyone serious about making money in the market (a less well-known book, "The Art of Speculation", by Philip L. Carret and first published in 1930 is right up there with The Intelligent Investor in my opinion, but a thorough analysis of the books' relative merits is for another day).

Perhaps if readers had to take a single concept away from Graham's book, it would be margin of safety. In his 1997 letter to investor, Warren Buffett compares the margin of safety when buying stocks to sound engineering:

You leave yourself an enormous margin of safety. You build a bridge that 30,000-pound trucks can go across and then you drive 10,000-pound trucks across it. That is the way I like to go across bridges.

In a nutshell, Graham advocates assessing the intrinsic value of a company by studying its financial statements and buying issues (stocks, bonds, warrants, etc) for the proverbial 50 cents on the dollar. One difficulty with this approach, however, lies in determining the asset's intrinsic value, let alone that different investors might use different valuation models. Serious analysis requires a considerable amount of time and involves listening to management conference calls as well as reading the company's annual reports to get acquainted with its business model and profitability. In addition, what is worth X to one investor might only be worth half of X to some other investor.

Here we propose a heuristic formulation of the margin of safety by applying a 30 percent mark-up to the stock's current market price rather than assessing the intrinsic value. Suppose that shares of stock ABC trade at $100 after today's close. Applying a 30 percent mark-up to the current price yields a target price of $130. Given the company's current fundamentals (earning per share, earning growth rate, debt-to-equity ratio, dividend yield, etc), the prospective investor needs to figure out how expensive the stock would be at a price of $130. If valuation remains attractive at that price, then the stock is a buy today.

Note that there is nothing sacred about the 30% number, but we thought it represents a large enough cushion to buy the stock at current levels. More conservative investors might work with a 50 percent mark-up for an even greater margin of safety, but doing so will inevitably reduce the number of attractive issues.

Let us illustrate our stock picking method with a few examples. Consider Google Inc. (GOOG). The stock made a low at around $475 last week courtesy of the now seemingly defunct market correction. Applying a 30% mark-up to $475 yields a target price of $617.50. Given the company's current fundamentals, how expensive would GOOG be at a price of $617.50? Let's check.

The Street expects earning per share of $34 for 2011. Since earnings have been growing at a 20% rate for the past 5 years, applying a multiple of 20 to earnings sounds reasonable for a PEG ratio of one (that is, investors pay one time the earnings growth rate). WIth the 20 multiple, the 12-month target price on Google comes to $680, a 43% discount to the $475 price tag. In other words, Google could advance by more than 40% from current levels and still be reasonably valued. Guess what? Chances are that Google will indeed advance by 40%, and therefore the stock should be bought today.

Following the proposed methodology, readers should check for themselves whether "old tech" stocks like Hewlett Packard (HPQ) at $35 or Microsoft (MSFT) at $25 are buys. What about General Motors (GM) at $30, investment bank Lazard (LAZ) at $37, or chip company Applied Materials (AMAT) at $13? All the aforementioned stocks trade at low P/Es, have high returns on equity and would still be reasonably valued should they advance by 30%. In our opinion, they are all screaming buys.

Now let us present an example of a company that does not offer enough margin of safety at current levels: Altria (MO). The stocks currently trades at $26.50. A 30% mark-up leads to a price of $35. Do the current fundamentals for MO support a $35 valuation? Let's review. MO is expecting to earn $2 per share in 2011 and earnings are growing at a rate of 10%. So at $35, the P/E ratio would be equal to 17.5. That is rather expensive for a company that only grows at 10% per year, implying a 1.75 PEG ratio (we suspect that the ultra generous 6% dividend yield and the clean balance sheet provides support to the stock in the mid-twenties).

We proposed an indirect extension of the margin of safety concept. Our idea is simple: should the stock under consideration advance by more than 30%, how expensive would it become given the current company's fundamentals? If the investor finds that the stock is reasonably valued after the advance and after further research determines that the company has a sound competitive business model, then the stock is a buy today. If not, investors should move on and look for better issues.

Disclosure: I am long GOOG, MSFT, LAZ, AMAT, GM.