Re: Yield On Cost A By-Product Of Investing With A Margin Of Safety

by: Daniel Radakovich


Discussion of what encompasses value investing including both quantitative and qualitative factors.

Overview of recent article about "yield on cost" and its flaws and benefits.

Why investing with a "margin of safety" is a superior strategy for all types of investors.

Investors typically describe value investing as a fundamental approach to determine how much one should pay for a business. I like to expand the definition as discovering why a company is valued the way it is, and if those reasons are unjustified, take action. Academics try to calculate and measure risk like beta and volatility. Risk is not quantifiable or measurable because there are too many scenarios and variables that can happen, yet only one thing happens. Retired or dividend seeking investors must understand that the most important thing for them to do is to control risk. The biggest and main risk of all investors is the permanent loss of capital. Fluctuations will exist and volatility can present serious psychological emotions to sell during a temporary downturn, but also present opportunities. Value investing is much more than just determining how fundamentally sound a company is. It not only controls and minimizes the risk of loss, but also improves the likelihood of higher returns. For this reason alone, value investing is a superior strategy for appreciation of capital and income.

I believe Seeking Alpha contributor Mr. Carnevale brought up a very valid point to look at "yield on cost" in his article here. I would like to expand on this theory and offer some additional insights into how one can achieve this through other means. Logically evaluating a company requires an investor to focus on both qualitative and quantitative factors. Wall Street focuses on quantitative factors greatly, as seen by the hiring of engineers in the financial industry. A complete waste of manpower and knowledge because they should be building infrastructure and solving complex real world problems instead of P/E ratios. The majority of investors believe value investing is as easy as finding companies with low P/E ratios, fundamentally strong business moats, predictable earnings growth, and established track record of dividends. These fundamental reasons were also given as the outcome for focusing on "yield on cost," but can also be possible outcomes after thorough value investment research. The root cause of these results stem from the true advantages of value investing, which is investing with a "margin of safety."

Quantitative factors that influence an investment decision are determining possible future owner's earnings and discounting them to present value as well as valuing the company's future growth. Qualitative factors are much more extensive and difficult; therefore, adjusting the discount rate is necessary to reflect uncertainties. One must account for how well management has executed multi-year plans and strategies, shareholder friendliness and capital allocation skills, and how likely the business will be able to build and expand the company's competitive moat. There are other quantitative and qualitative factors as well that change depending on the type of investment, which is why an investor's competence is gravely important. For instance, investors can have substantial returns and eliminate risks by having unique instincts about a particular industry or a company's products and services. Discovering excellent opportunities are scarce and require a lot of work and effort, which is why diversification often fails to beat the returns of concentrated portfolios of truly great companies over the long term.

The author also diversified his client's portfolio with 20 companies covering a wide range of industries and sectors. Conceptually, modern portfolio theorists and others believe that diversification and rational markets say this should improve investor returns and eliminate risk. The S&P 500 since January 2006 with all dividends reinvested has an annualized return of 6.68%. The single client's portfolio is higher than that by just under 2% annualized, although the exact figure cannot be known due to discrepancies given by the author and unknown client fees. Risk is often overlooked and can easily seem to confirm skill instead of luck and have investment decisions appear less risky than they were at the time. For instance, below are some questions that shot through my mind instantly:

  • Are 20 companies too many or is it just right?
  • How much risk was involved at the time, and what if the financial crisis hit in 2006 instead of 2008?
  • The companies invested in all were sound businesses, but would the clients have been better off using the top 3 or top 5 ideas of the advisor at the time?
  • Would they also have been better off having spare cash to invest in future opportunistic times?

Before an investor completely prescribes by the dividend income investing thesis, one should take an outside look at some external causes for their returns and failures. Luck and risk cannot be under estimated.

Clearly, the "yield on cost" strategy helps eliminate risky investments that can fool investors and cause big mistakes and loss of capital. Beforehand, the author stated that the client's funds were in an absolute total return portfolio with high-growth stocks, which in this case paid off handsomely. How would those stocks and portfolio have done if the changes were performed later, or if market conditions changed sooner for the worse? The risk of permanent capital loss can be a major factor when rotating different portfolios to meet different objectives. The advisor did a good job convening the clients not to sell due to fear, which would have locked in the loss during a temporary downturn. Many investors make this mistake. As Buffett has said in the past, when the tide goes out, we see who is naked. One portfolio and one client presentation is obviously not a perfect sample set, but I still would like to highlight these concerns.

Buffett in his 2013 annual letter recommended investors just invest in the Vanguard S&P 500 index fund. Many investors have followed his advice this year, as evidenced by the huge inflows into Vanguard's index funds. However, Charlie Munger has given different advice to institutional clients and high net worth individuals about how to invest and has done so with his involvement with Daily Journal Corp. (NASDAQ:DJCO). He prescribes a simple theory, that if one invests in a few well-run companies with honest and competent management, with high returns on capital, then one should outperform the markets as a whole and enjoy substantial returns if these companies are bought at a fair price. Value investing with a twist. Buying great companies at a fair price. We have all heard it, but few practice it. Buffett has also prescribed this philosophy numerous times as well. Especially in a concentrated form. While this increases the risk for a concentrated bet to go bad, having patience and courage to invest when opportunities present themselves lowers this risk as well as others. Including the risk that future consumer or customer preferences change, interest rate changes, inflation, or someone like Sam Walton entering your industry and changing how everything is done. One must always be on the lookout for that. When you think about it, using metrics and graphs are a simple way to do your homework. They do not tell you what is going on, what is changing on the micro level, and future disruptions in the business model. Qualitative factors are hard to measure; therefore, hardly mentioned by Wall Street analysts or financial advisors. Continually monitoring 20 investments, or well over 20 investments is an expensive and difficult job.

I believe financial advisors get two things wrong big time. One, they charge fees based on assets under management without having to meet a certain watermark. Two, they invest nearly 100% of clients' funds on the premise that nobody can beat the market and leave no funds left over to invest during opportunistic times. While you can't predict the future and future forecasts are always up in the air, one can hold cash and be patient awaiting future opportunities. You must take risk in order to earn higher returns and controlling that risk is paramount. The theory of investing with a "margin of safety," in my opinion, is why the "yield on cost" metric was successful on the surface. The majority of those companies was able to reinvest their earnings during the recession and continue to generate strong returns of capital both in the U.S. and abroad. Additionally, they had, for the most part, competent management and sound capital allocation strategies and were not tied too heavily to the financial markets and cyclical downturn of the credit cycle. During this downturn, if one was patient with cash, not only could they have invested in large financial institutions like Wells Fargo (NYSE:WFC), US Bank (NYSE:USB), JPMorgan (NYSE:JPM), American Express (NYSE:AXP), but they could have earned significantly higher returns and "yield on cost."

A company's capital allocation strategy is single-handedly the CEO's most important job. A business that is not capital intensive with strong cash flows and earnings can focus on acquisitions to build value and share repurchases when shares are believed to be undervalued. Once those resources are complete, they usually have a dividend policy that will institute an increasing dividend correlated with earnings growth. Here lies one risk for "yield on cost." The market knows the history and likely future of the company and is well aware of the potential for future dividend growth for a fundamentally strong company. Thus, if one is wrong about a company's future prospects or earnings growth, then sentiment can permanently change due to a substantial drop in the value of the business. Diversification does not eliminate this risk. Only due diligence, competence, temperance, and patience can help reduce the likelihood of being wrong while at the same time eliminating the majority of big mistakes that can ruin investors.

Take Apple (NASDAQ:AAPL) and Microsoft (NASDAQ:MSFT), for example. Mr. Market several times in the past 10 years has underappreciated their earnings potential and has been underwhelmed by their capital allocation strategy. Both of their business models and competitive moats are uniquely strong that provide substantial cash flows. Investors in these two companies benefited from the following: a continuation of increased earnings and cash flows, a reduction of shares outstanding while undervalued, redeployment of earnings into businesses generating substantial returns on capital, long-term tailwinds in current industries, and new forms of growth by expanding into new ventures and markets.

I encourage dividend income investors, retired investors, financial advisors, and others to broaden their scope of what value investing is. Take a strong look at Mark Hughes' Most Important Thing and his memos. Additionally, read anything by Buffett and Munger, including Poor Charlie's Almanac. We are in a low interest rate environment. The economy in the U.S. has staggered slowly in its way forward, which is not necessarily a bad thing. The savers in this economy are being punished. The equity and bond markets are highly competitive. With everyone looking for yield, the biggest risk seems to be in the junk bond market, where one is reaching outside their areas of competence to earn an extra buck and justifying it by saying it's a difficult market and having conformational bias with others doing so as well. I would be very careful in the equity markets because there are growth stocks that have insane valuations priced to perfection 20 years from now on a discounted cash flow basis. MLP structures and high-yielding REITs are also prime candidates for investors to exit their areas of competence. Investors like to think that if something has not happened, it can't happen.

The "yield on cost" metric really should make investors think twice about what is really working. Is it really just focusing on companies that are fundamentally strong dividend payers, or is it the result of something else? Ask yourself if you would do better focusing on your top 3 or 5 ideas and invest accordingly, keeping a close watch on each one rather than relying on metrics and conformational bias. Stock prices are determined by earnings in the long run. Earnings are determined by the return of capital employed by the business throughout the years. Acquisitions, share repurchases, and dividends are a byproduct of a great company that does these things very well. Price is paramount. Avoid paying lofty prices and look to buy when the market is fearful or when you know you are getting a fair price. I think you would do better in absolute terms and in income. Think of how well Buffett's dividend investing income is, and he has never used the term "yield on cost." He uses a "margin of safety." It controls and minimizes the risk while at the same time increases returns. Perfect this, and you have a chance at becoming a successful investor.

Thanks for reading.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.