Responding To Margin Of Safety Myths

|
Includes: FMC
by: Cory Cramer

Summary

Noted valuation expert Professor Damodaran recently published a blog post that included several myths regarding the concept of margin of safety.

I craft a personal response based on my own investment approach and explain how I define and use margin of safety.

I encourage all value investors to participate in a similar exercise so that they can ensure their use of margin of safety is coherent.

Introduction:

Seeking Alpha contributor Terrier Investing recently published an article titled "Why Professor Damodaran Is Wrong On Margin Of Safety" in response to a blog post of Professor Damodaran's that in Terrier's words "presented a negative bias towards the core concept of value investing: margin of safety." Terrier went on to explain that in his view margin of safety is:

...not a specific tool for arriving at a fair value (or buy price) for specific companies. It's an overarching philosophy that drives every aspect of my investment process, from the prices I'm willing to pay to the companies I'm willing to invest in and the general way in which I approach the investing world. It's a mindset designed with the paradigm that I'm a human with feelings and follies, not a robot or algorithm that mechanically applies mathematical frameworks.

My article is not intended to be a response to Terrier Investing or a critique of Professor Damodaran's blog post. My goal with this article is to encourage investors to closely examine Damodaran's critique of MOS, and to craft their own personal responses, just as Terrier Investing did (and just as I am about to do). The process of doing so should improve all of our investing processes by potential identifying weaknesses in them so that we can make adjustments to ensure our individual understanding of margin of safety is a coherent one.

With that said, let me take you through my personal response to Professor Damodaran's critique with regard to my own investing style and how it relates to MOS. The professor did an excellent job summarizing a couple of the common definitions used by value investors regarding MOS, so I'll quote him:

While the margin of safety has always been around, in one form or another, in investing, it was Ben Graham who brought the term into value investing in The Intelligent Investor, when he argued that the secret of sound investment is to have a margin of safety, with the margin of safety defined as the difference between the value of an asset and its price. The definitive book on MOS was written by Seth Klarman, a value investing icon... Klarman's take on margin of safety is similar in spirit to Graham's measure, with an asset-based focus on value, which is captured in his argument that investors gain the margin of safety by "buying at a significant discount to underlying business value and giving preference to tangible assets over intangibles"

(I encourage everyone to read the entire post DCF Myth 3.1: The Margin of Safety - Tool for Action or Excuse for Inaction? at some point).

My application of margin of safety is different from both Graham's and Klarman's. That doesn't mean that I deny their respective approaches are a type of MOS. They certainly are. But mine is a little different and it has implications for my responses to Damodaran's critique. The definition of MOS that I practice the most is: The distance between the purchase price of a stock and a previous market price established under market conditions we can reasonably expect will happen again within a specific time period.

In order to gain a better understand of my approach, we have to examine valuation's relationship to MOS:

Many great investors have a philosopher from outside of investing that has highly influenced their investing approach. For example, Charlie Munger has Benjamin Franklin while George Soros has Karl Popper. Much of their "edge" in investing has come from creating personal modifications or expansions of these outside influences and applying them to investing. It allows the investors to make decisions that are both contrarian and correct. My philosophical role model from outside the investment world is 18th century statesman Edmund Burke.

In many respects, my overall approach to the market is a combination of Burkian use of precedent and George Soros's understanding of reflexivity and fallibility. It is in these areas of social and political theory I have learned the most, and where I believe the theoretical underpinnings of much of Howard Marks's advice on economic cycles can be found.

There were few historical statesmen who were shown to be as correct about public policy as Edmund Burke. In the second half of the 18th century, he advocated for religious tolerance toward Catholics, more open trade policies, reconciliation with the American colonies instead of war, wrote famously against the dangers of radical revolutions like those in France, and spoke out against the mistreatment of the Indian people by the English. The two main reasons I think Burke so often ended up on the right side of history was (1) his policy of using previous historical precedent to help guide his decision-making, and (2) his policy of being skeptical about the predicted effects of drastic policy changes on complex social systems (especially if they assumed a priori knowledge and lacked historical precedent). In order for someone to be able to do what Burke did as well as he did it, they must first possess a lot of historical knowledge. Second, they cannot let a predetermined ideology cloud their judgment and interpretation of history and public policy (Munger and Buffett have warned against this as well). Yet, most traders and investors do not read and understand history and many let ideology drive their investment decisions (just read the comments on any article about gold or the federal reserve for examples). This is a place where I can gain an edge on much of the investment community, and then try to work that edge into my overall strategy and understanding of margin of safety.

There are trillions of complex interactions taking place in a marketplace just as there are in any social and political community, but just as Burke was able to look to the past for some guide on how public policy changes might affect the future, my view is that if I can look at how a company's stock has performed in the past, then that can serve as a guide for how the stock might perform under similar conditions in the future.

I do have to make a major assumption in order for this hypothesis to work, however. I have to assume that we are dealing with cyclical and not linear environments. What this means is that we cannot simply extrapolate past performance and assume a stock will rise or fall in a linear fashion. Even the longest "dividend streak," for example, should best be understood in terms of a stock that is part of a long cycle, not something that will last "forever." The Pennsylvania Railroad paid dividends for 100 years, but then went bankrupt in 1970. Nothing is forever.

Again, Soros was a great student of history and philosophy. He understood that markets were complex and social. He noticed that at times they could get drastically out of balance or "far from equilibrium," and that these times presented good investment opportunities. In order to have a reasonable understanding of approximately where equilibrium may be, however, one has to use history as a guide, in my opinion. There is no other good reference point.

The upshot of all this is if I see a stock trading significantly lower than it was a year ago or two years ago, I know that there is historical precedent for a higher price for the stock. I know with certainty that at an earlier time someone was willing to pay a specific price. This is much like when a company receives a buyout offer. We then know there is someone willing to pay that particular price out there in the market. The second part of this is that I know I cannot predict the future with very much precision, but that I can probably improve my prediction if there is a wide divergence from past precedent.

Putting all this together, having as wide of a spread as possible between the previous market price of a stock and its current price, while taking into account the stock's historical range of cyclicality is essential to make up for the fact that in most cases we cannot be very precise when dealing with complex social systems in which the participants themselves influence the predicted outcomes (reflexivity and fallibility).

So what does all this mean? Basically, it means that my method of valuation mostly involves looking at what the market priced a stock for in the past. What I assume is that external market conditions are cyclical and that eventually similar conditions will arise in the future that we had in the past (provided those conditions didn't occur during a bubble, and that the company's business model isn't subject to immediate disruption).

For example, I recommended buying FMC right around $40 per share on 3/31/16. Just two years earlier, FMC traded at over $80. So, provided my other investment conditions were met, FMC's "fair value" (or, likely future value within five years) is $80 or so, and by buying FMC at $40, my margin of safety is ~50%. FMC Chart

FMC data by YCharts

So far, this investment is doing well:

FMC Total Return Price Chart

FMC Total Return Price data by YCharts

And, if similar market conditions experienced in 2014 repeat, I should be able to make a 100% return on FMC.

Note that this is very different than Graham or Klarman, but it is still a type of valuation that can help provide a margin of safety.

On the issues of magnitude and variability, I agree with Professor Damodaran that MOS must be variable and it must be company specific. I may only require a 35% discount from a previous price for a mature and stable company while requiring a 70% discount for a younger cyclical company. I calculate each of these myself using my own method based on past cycles and likelihood of business model disruption.

Damodaran also noted several myths with regard to margin of safety in his post, and I want to respond to those as well:

  1. Myth 1: There is no cost for MOS - I agree that there is an opportunity cost for margin of safety if one cannot find enough investments. There is a balance one must strike between the size of margin of safety required, position size, and frequency of occurrence in the marketplace. This is constantly a work in progress for me, but I think the most important point in this regard is that I don't let current macro conditions dictate my cash position for individual stock accounts. My cash position is simply determined by what I can find at any given time in the market. I have devised a system that allows me to make my initial bets quickly, though, which serves to increase the frequency of occurrence and lower opportunity costs from stocks I missed.
  2. Myth 2: You can be sloppy with valuations - I actually spend a lot of time on valuations; they are just done entirely differently than the way most other investors do them. I also am prepared to make up to three bets on a company, so I do much more analysis on the second and third bets than the first. There is really a balance that must be struck between acting quickly, so as to not miss opportunities and being careful enough in understanding the company and why they are trading at a discount to their previous price.
  3. Myth 3: The margin of safety should be the same across all investments - I completely agree that MOS should not be the same for all investments and I individualize each MOS calculation, however, I start with a preference for those with larger MOS, and only if I can't find enough of them, do I move on to those companies with smaller MOS.
  4. Myth 4: The MOS on your portfolio = MOS on individual investments in the portfolio. Again, I completely agree with Damodaran. At any given time, especially as a stock I have purchased climbs towards a previous established market price (fair value), its MOS will naturally decline. That's fine. I focus on establishing the buying price and the selling price before I purchase. Not to mention, that each stock has its own MOS with my approach.
  5. Myth 5: MOS is an alternative risk measure. Again I agree. I also don't think beta is a good risk measure, either. Risk is the probability that the external market environment will not allow for the stock to return to its previous market price in a timely manner, or that a disruption will occur to the company's business itself. I use multiple historical cycles as a guide, and add on relative debt and imminent threats to business models as risk factors. The margin of safety itself is not enough.
  6. Myth 6: Buying and holding forever is consistent with MOS and value investing. I completely agree with Damodaran again. If a stock becomes fairly valued, one must either stop considering it a value investment and start treating it like a growth investment, or sell it. Selling a stock is tricky, but using my philosophy, one would want to sell before a stock reaches new highs, at which point the MOS would be gone. The stock may still be worth holding, but it would have to be evaluated using a different method that takes into account more traditional valuation methods that project asset value and future earnings growth. Nothing wrong with that, but it requires a different approach.

Conclusion

It would probably take a thousand pages to do justice to the theoretical underpinnings of my investment approach, but it's not really important that I do that because this exercise was mostly for myself. It was a way for me to make sure that I could give a coherent response to Professor Damodaran's critique of margin of safety and valuation, just as Terrier Investing had his own unique response.

What I think is important is that any investor who uses margin of safety as an investment tool be able to provide their own response. So, I'm curious. Do you use margin of safety as part of your investment process? If you do, how would you respond to Damodaran's critiques? Is there anything you think you would change about your approach after reading his critique?

Disclosure: I am/we are long FMC.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.