In my former career I negotiated and managed contracts for a large company. These contracts varied but periodically would be for large equipment such as lifting or load supporting equipment. Whenever I would purchase something along one of these lines, a crane for example, we would always perform an overload test, usually around 150%, to ensure the equipment could safely meet our expectations before we accepted it. This was so that if someone accidentally lifted something heavier than the equipment was rated, it would provide a margin of safety. And a margin of safety is something I want for my dividend growth investments.
Investopedia defines margin of safety as "a principle of investing in which an investor only purchases securities when the market price is significantly below its intrinsic value." In his book "Margin Of Safety" Seth Klarman said "A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world." Margin of safety has been around for years, originally popularized by Benjamin Graham who is considered the father of value investing. He insisted on only buying a stock at a significant discount or when it was a bargain to its valuation or worth. His most famous student, Warren Buffett later deviated somewhat from the classical Graham approach of buying dollar bills for fifty cents. Buffett now says:
It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.
-- giving credit to Charlie Munger for changing his views on this philosophy, stating that "Charlie shoved me in the direction of not just buying bargains, as Ben Graham had taught me. This was the real impact Charlie had on me. It took a powerful force to move me on from Graham's limiting views."
I define fairly priced as meaning at or less than intrinsic value, or IV. Others may define it differently. But since my long term focus is on income I realize that the more I pay for a company today the less I will receive in income in the future. With that in mind I use a 2 part margin of safety, with the first part to make sure I pay a fair price. To that end I calculate the IV.
Margin of Safety - Part 1 - Price
With a price margin of safety I'm placing more weight or emphasis on buying at or below the IV price which tips the scale balance toward price. In reality there are multiple ways to calculate fair value and it's as much art as science. Some dividend growth investors will also look to buy at a specific yield and use that as their fair value. There are multiple sites available to obtain information concerning IV or worth and whether a company is fair, over, or under-valued. Fast Graphs is an excellent one, along with Morningstar. You can also calculate it yourself using a variety of methods such as shown here and here. I calculate the IV and identify a range where if the stock price moves within that range I consider it a buy zone. For example, I recently bought Norfolk Southern (NSC). I believed the fundamentals were good and I had calculated the IV to be about $75. NSC is a cyclical that has for the most part been trading in a horizontal range. Since it was below my IV level I placed an order and bought it at $64.40, which was about 14% below my IV.
While a lot of value investors look for anywhere from 30% to 50% below the calculated value, I simply look for a reasonable discount. After I calculate the intrinsic value I'll compare my estimate to the information from this site since it shows 3 different calculations, Mean Multiple Value, Graham Intrinsic Value, and Greenblatt Fair Value (enter company name under analyzer tab to get results). For NSC it calculated the Mean Multiple Value to be $69.71, Graham Intrinsic Value to be $63.69, and Greenblatt Fair Value to be $90.19. I do this comparison as a sanity check and to verify I haven't wandered off in left field.
I use a buy zone because of previous experience trading. I was taught to use a "crayon" when drawing support/resistance lines on charts, meaning don't make the line so narrow you miss the actual area. Ultimately I want to get in the price zone, not necessarily nail an exact price. Also, one of the reasons I check the charts after calculating IV is to see how often, or even if, it trades at or below the IV. There are some companies that seem to always trade above IV, or at high P/Es. In those cases I have to make a judgment call of just how badly I want to own that particular company and, if so, where my buy zone would be.
Margin of Safety - Part 2 - Economic Moat
Buying at an under-valued price provides a margin of safety on price. But what about the wonderful company part of Buffett's statement? Buffett also said to
only buy something that you'd be perfectly happy to hold if the market shut down for 10 years…
My second margin of safety part gives more weight to the company and requires it to have a competitive advantage or economic moat. Purists may say it's not a margin of safety but I would argue that if I make an error on IV, owning a wonderful company gives me an extra margin on price. I tend to hold my core investments until company fundamentals say to get rid of them and because of that I may have to endure wider swings in the market price rather than getting out and trying to get back in, especially if I buy above the IV price. And if I'm going to endure wider swings then I need to have confidence that in holding those positions I've made the right decision. Buffett also said,
The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.
The use of an economic moat has to be more than lip service by the investor. When looking at a company's economic moat I ask how easily can a competitor cross it? If it's easily breached then it's not durable. While there are a number of different kinds of moats, here are the ones I look for along with examples of each:
Brand - An example of a brand moat is Coca Cola (KO). In fact, Coke was recently selected by Interbrand as the number one brand for the entire planet for 2012. Coke has been paying a growing dividend for 50 years. They say don't get married to a stock and while I'm not married to Coke, I may have a crush on it. They are the number one soft drink company in the world and have an extremely strong brand moat. But brand doesn't guarantee continued success as Hewlett-Packard (HPQ), the No. 15 company on the list, demonstrates. Also note that Morningstar includes brand under its intangible asset moat list.
Price/Economy of Scale - Wal-Mart (WMT) has a price or economy of scale moat. Because of the sheer magnitude of their operations it is difficult for companies to compete against them. Conversely Sears (SHLD), once the nation's largest retailer, has proven over the past several years someone with a better economy of scale eventually comes along.
Legal Monopoly/Toll/Barrier To Entry - For years AT&T (T) had a legal monopoly until the government decided to break it up. Currently though many utilities have legal monopolies. Southern Company (SO) for example serves a 120,000 square mile area in the Southeastern US, covering portions of the states of Alabama, Georgia, Florida, Mississippi, and the Carolinas. It has a 4.5 million retail customer base that it services through its four subsidiaries - Alabama Power, Georgia Power, Gulf Power, and Mississippi Power. If you need electricity in this area, then it's predominantly coming from the Southern Company. To me that's a strong moat but the downside for investors is that their ability to increase prices is regulated by the government which limits growth.
Switching - A switching moat exists when it would be too costly to switch from one product to another. For example, Microsoft (MSFT) has a switching moat because of its windows operating system, along with its Office suite of products such as Excel, being the primary desktop software used in most industries. That moat has allowed them to accumulate over $29 billion in free cash flow. For a company to make a wholesale switch to another product would be too costly so they continue to use the Microsoft products. One could argue the PC industry is undergoing a sea change so Microsoft will need to adapt accordingly to protect their moat.
Secret or Intangible Assets - A company has a secret asset moat when they have a patented product that no other company can legally manufacture and sell. Drug companies often fit in this area, but when their patents expire they can lose market share quickly to generic producers. In fact, Pfizer (PFE) dropped its price on Lipitor, the best selling drug of all-time, by 80% from its original cost, which impacts revenue. But a conglomerate like 3M Company (MMM), which has 23,800 patents spread across a variety of business sectors, may have a wider moat. Pfizer has multiple patents as well and continually has new products (currently 87) in their pipeline. I'm not knocking Pfizer or advocating 3M, I'm simply saying that one must consider the durability or lifetime of the intangible asset when considering that as a moat.
While these economic moats all provide some degree or margin of safety they are not fool proof just as the intrinsic value calculation is not error proof. Moats can and do come under attack. All of them have their limitations, their strengths and weaknesses that have to be considered.
In reviewing NSC I decided their 20,000 miles of track and service area provided them a decent barrier to entry moat. They cover the majority of the eastern US from New Orleans to Chicago over to New York. They are one of only seven Class 1 railroads in the US. The durability is resistance to new entrants into their market. Probably their largest direct competitor is CSX, but I liked NSC's larger dividend. Since they are a cyclical I may not hold them as long as I would a KO or PG but having a decent moat and dividend gives me a little more comfort while I do.
The Real Margin of Safety
There's nothing new about identifying companies with economic moats and then calculating intrinsic value and the discount price at which to buy. But being diligent about it and making it a required part of our process can add a margin of safety to our investments. Ultimately though, I think that my true and best margin of safety is actually myself. If I'm too lazy or not willing to do due diligence, then no margin of safety, price or company, will protect me. I have to continue to work on cultivating and maintaining the personal characteristics and qualities to be a successful long term investor, including patience, common sense, being willing to admit mistakes and accept responsibility for my own decisions rather than blaming others, and the intestinal fortitude to avoid panicking on price volatility.
I also try to continually improve my knowledge base to become a better investor, especially learning from others who are willing to share their knowledge. Buffett admitted that he learned from Charlie Munger. If the most famous, and arguably the best, investor in the world can learn from others, shouldn't we try to do so? It may mean we have to be willing to consider other approaches, push aside some of our biases, and admit there are things we don't know. Perhaps our best investments may be in our individual selves. And the more that we can invest in ourselves in time and study then the better investors we will become, and the greater our margin of safety. As Peter Lynch has so eloquently stated it,
It is personal preparation, as much as knowledge and research, that distinguishes the successful stockpicker from the chronic loser. Ultimately it is not the stock market nor even the companies themselves that determine an investor's fate. It is the investor.
Additional disclosure: I am not a professional investment advisor, just an individual handling his own account with his own money. You should do your own due diligence before investing your own funds.