How To Lower Risk And Build A Margin Of Safety

Includes: JNJ, KO, PEP, PG, T, XOM
by: Tim McAleenan Jr.

If Benjamin Graham had boiled his investing philosophy down to three words, they would have been “margin of safety.” At the beginning of Chapter XVI of his famous work The Intelligent Investor, he outlines the philosophical rationale for investors to pursue the greatest amount of margin of safety—that is, room for error—that can protect them from disappointing returns over the long-run. The inherent riskiness of the stock market is one of the greatest deterrents that prevent people from building sizable long-term investments in companies like Coca-Cola (NYSE:KO) and Johnson & Johnson (NYSE:JNJ). On page 241, he opens the chapter by saying:

In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, ‘This too shall 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 the idea in a connected argument.…The margin of safety is dependent on the price paid. It will be large at one price, small at some other price, and nonexistent at some higher price.

This is one of the funny paradoxes of investing—in the 1990s, when stocks were doubling and tripling every time somebody sneezed, very few people began to think of stocks as becoming riskier. The financial news networks didn’t pick up the theme of ‘stock riskiness’ until the recession of 2008 came along and sent prices plummeting. I can certainly understand why this is the case—watching $200,000 turn into $130,000 in your brokerage account seems to represent everything bad that risk entails.

But of course, folks like Benjamin Graham, or investors with a very long-term mindset, would see things differently. If you are perfectly comfortable thinking of your stock investments as partial ownerships in companies (which they actually are) instead of three-lettered blips on the screen, then you’ll not only be able to gain a better appreciation for what risk really means for the long-term investor, but you’ll be more likely to pounce and invest aggressively during times of significant stock market declines.

In Benjamin Graham’s case, he tried to ensure long-term investing success by only making investments in companies that he thought were trading at 33% less than what they were worth. He got this number from one of his friends who was a construction worker that built bridges, and he talked to Graham about how a bridge that claimed to have a 20,000 pound limit would have to be built to hold 26,600 pounds of weight, at a minimum, to reduce the risk of a bridge collapsing if a bunch of heavy trucks drove over the bridge at the same time.

In this spirit, Graham would calculate what he believed a company to be worth, and then begin buying shares once they started trading for a third less than that. Let’s say that you expect Exxon Mobil (NYSE:XOM) to grow its earnings per share by 12% annually and its dividends by 8.5% annually over the next eight years, and then you calculate that the shares of Exxon are worth $95 per share, in your opinion. At that point, you would consider buying shares of Exxon anytime the share price dipped below $63.65. This builds into your investment a substantial margin of safety so that you can do quite well even if you make a misjudgement in your calculations—let’s say Exxon only grows earnings by 6% annually, or the dividend only grows by 2%, or Exxon experiences another crash like the ExxonValdez over the coming few years. By purchasing the shares with a built-in margin of safety, you will have eliminated a substantial amount of the risk because Exxon could perform below your expectations and you could still come out ahead as an investment.

So how should this affect your thought process on risk? Well, during times of market downturn, you should first focus on whether the long-term earnings power of the firm you’re focusing on has been compromised. When the recession hit in 2008, did that lead you to believe that Proctor & Gamble (NYSE:PG) would be selling fewer Gillette razors in 2014, or that Heinz (HNZ) would be selling less ketchup in 2016? If you don’t think that the earnings power of the company in focus has been compromised, then you can use the market hysteria brought about by falling stock prices to lock-in on some shares that contain a significant margin of safety. Shares of AT&T (NYSE:T) fell to $21 in 2008 relative to $2.16 in per share earnings—if the company’s earnings potential was not hindered, then buying shares of AT&T became much less risky than they were at the start of 2008 when shares traded at $41 per share, because the much lower price represented a much larger margin of safety in your investment. When you’re only paying 10x earnings for stock, you can stomach a lot more to go wrong than when you purchase a stock at 20x earnings.

Think of it like this; for every $1 you invest in Pepsi (NYSE:PEP) stock today, you are entitled to a little over $0.06 in earnings. In the long-term, you make money investing by buying the greatest amount of a company’s profits at the lowest possible price. If your assessment of the company’s long-term growth prospects are undiminished, then you ought to think that declining stock prices make your potential investments less risky. After all, if you think Pepsi is going to grow its earnings and dividends by 9% annually over the coming years, why wouldn’t you enjoy seeing the price of Pepsi stock get cut in half so your initial investment can represent $0.12 of profit for each dollar invested instead of $0.06? Each dollar we invest in a company in turn represents a true proportional claim to ownership of a company’s earnings, and as long as those earnings aren’t impaired, every dollar decline in stock prices gives you a greater amount of profits to own for each dollar invested, which creates a margin of safety that lowers the risk of your investment.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.