Searching For A Wide Margin Of Safety In An Uncertain Market

by: David J. Waldron
Summary

At Main Street Value Investor, we buy and hold the stocks of quality companies with history and the continued likelihood of compounding total returns from capital gains and dividends.

Especially in this uncertain market, it is crucial to evaluate downside risk and other measurements of the stock's margin of safety.

Warren Buffett perhaps said it best, "Price is what you pay; value is what you get."

Investing with a margin of safety is defined as the difference between the estimated intrinsic value of the stock and its current market price.

Powered by Ivy-League degrees and sophisticated software, Wall Street disseminates complex, assumptive financial models of seemingly precision earnings estimates and price targets, each market day.

But many of those projections ultimately play-out as no more intuitive than a crystal ball; otherwise, the investment elite would be as wealthy from portfolio performance as they are from fees and bonuses.

We take a more straightforward, realistic approach to measuring intrinsic value by instead focusing on five controllable quantitative areas that gauge enduring value from the compounding stocks of quality companies.

But inevitably the herd will ask, "At what specific price will the stock be trading next week, next year, and in the year 2028?" My answer:

I Don't Know (Source: Wok and Apix/Pixabay)

However, I do know that investing in stocks with a wide margin of safety is our best case scenario for portfolio success over a lifetime, not just a single bull market.

Margin of Safety in Practice and by Proxy

In general, a stock's margin of safety is calculated in one of two ways: the more common attempt of predicting the actual intrinsic value of the equity and then subtracting that estimate from the current price; and the more practical calculation of whether the stock represents a quality, enduring company currently trading at a reasonable price. The former requires high intelligence and plenty of assumptions, the latter works with thought, discipline, and patience in a review of the facts.

Margin of Safety in Practice

Some well-intentioned professional investors prefer to calculate the margin of safety with discounted future free cash flow projections and other future-focused and therefore assumptive estimates of precision price targets within specific time frames.

Such overly sophisticated margin of safety or intrinsic value estimates are what allegedly justify the high fee structure of Wall Street. However, we are suspect of the projection nature of these formulas. If we have to start predicting future cash flows, interest rates, and capital expenditures, haven't we become more a speculator and less an investor?

Margin of Safety by Proxy

To the contrary, at Main Street Value Investor (MSVI), we take a modest and frankly realistic approach to estimating intrinsic value. Thus, we prefer to measure the margin of safety in a broader sense as opposed to Magic 8 Ball (MAT) specificity.

The MSVI margin of safety model screens for reasonably priced stocks of companies with favorable earnings and free cash flow yields compared to the ten-year Treasury rate; adequate returns on equity, assets, and invested capital; attractive prices to sales, operating cash flow, and enterprise value to operating earnings; and controllable long- and short-term debt coverage. Thus, we are assessing the overall equity bond rates, earnings quality, management effectiveness, market valuation, and financial stability of the company.

We believe our calculation of margin of safety is a useful measure of a company's intrinsic worth based on current and trailing indices as opposed to assumptive future cash flows and other crystal ball projections. Ultimately, we measure the margin of safety for longer-term value investing as opposed to shorter-term momentum trading.

We own common shares for the long-term benefit of partnering with a company that supports its customers with in-demand, useful products or services, rewards its employees with sustainable career opportunities, and compensates its shareholders with positive returns protected by world-class internal financial controls.

However, attempting to predict specific future prices or percentage gains and declines is a Wall Street game of chance that we respectfully choose to avoid on Main Street.

That written, it is important to stress that our measure of the margin of safety for individual stocks is a screenshot of our research and not a buy, hold, or sell signal. Readers are reminded to conduct his or her due diligence before investing.

Cigar Butts or an Enduring Bottle of Red?

(Source: Paolo Falcioni/Pixabay)

I am forever seeking great companies whose common shares are trading at fair prices as the most profitable approach to investing. The cigar butts and special situations are more about trading stocks and practicing arbitrage than investing in companies and are hence, purely speculative. We equate the endurance of a quality enterprise to a long-lasting bottle of fine wine.

I think Peter Lynch sums it up best in his book, Beating the Street (New York: Simon & Schuster, 1993):

Often, there is no correlation between the success of a company's operations and the success of its stock over a few months or even a few years. In the long term, there is 100% correlation between the success of a company and the success of its stock. This disparity is the key to making money; it pays to be patient, and to own successful companies.

At Main Street Value Investor, we are not smart enough - or foolish enough - to time the market, but instead, we search for a wide margin of safety in five key quantitative areas of a targeted company's operational and equity performances: value proposition, shareholder yields, returns on management, valuation multiples, and downside risk.

Value Proposition

At MSVI, quality and price take the front seat in all of our equity research. We define value investing as a relentless commitment to both the price of the stock and the quality of the company.

In the priceless wisdom of legendary investor, Warren Buffett:

Price is what you pay, and value is what you get.

Thus, a company exhibiting a well-defined value proposition is as prized as a stock trading at attractive valuation multiples.

The Intrinsic Value of an SEC Filing

As the starting point of any investment research, reading the company's Form 10-K annual report submitted to the Securities and Exchange Commission as well as reviewing the organizations' investor relations site should be jobs one and two for the self-directed investor.

I challenge readers that may be inclined to skip annual reports and other SEC filings to find organizational, product, regulatory, and financial facts about the company that you were previously unaware of, as I often do. To be sure, these documents are mostly avalanches of legalese and numbers crunching, but deep dives will often uncover slices of information that bring us virtually inside the company's plants, stores, C-suites, and boardrooms.

Company Profile

Our targeted investments are the U.S. major exchange-traded, small-, mid-, and large-cap common shares of high quality, dividend-paying companies.

We avoid over-the-the counter issues [OTC] and micro caps as speculative.

Historical Performance Versus the S&P 500

Past performance does not predict future returns, but we want to own wonderful companies represented by reasonably priced stocks with a history of beating its benchmark.

Chart

(Source: YCharts)

Competitive Advantages of the Company's Products or Services

Instead of chasing the dragon, we invest in companies producing worthwhile and profitable products or services that assist consumers worldwide in solving personal and business problems and satisfying wants or needs. The Main Street Value Investor Model Portfolio resembles a collection of owned slices of well-managed companies that are producing in-demand products or services with enduring competitive advantages.

Based on our relentless commitment to both price and quality, here is MSVI's investment objective:

Buy and hold U.S. exchange-traded, dividend-paying, well managed, financially sound businesses, or funds of companies that produce easy to understand products or services, have enduring competitive advantages from wide economic moats, enjoy steady free cash flow, and are trading at a discount to our perceived intrinsic value at the time of purchase. Then, of utmost importance and perhaps the biggest challenge, practice patience in waiting for our investment thesis to play out as projected over a long-term horizon.

MSVI's investment objective enthusiastically follows the rational wisdom of the Oracle of Omaha. As reiterated in the excellent HBO documentary, Becoming Warren Buffett, he endured a transformation from buying cheap companies, regardless of quality, and unlocking value through corporate events, i.e., dump the stock when the price increased to a profitable level; to buying and holding wonderful companies at fair prices and taking advantage of the magic of compounding.

Buffett acknowledges that it was under the tutelage of his partner Charlie Munger that he transformed from a stock trader (cigar butts) to a company investor (fine wine.)

As influenced by Buffett and Munger, we prefer investing in quality, enduring companies as opposed to trading in speculative, faceless stocks.

So how do we measure the quality of a company's product or services and its competitive advantages to its perceived enduring value relative to its current price?

We first measure how the company's value proposition rewards its shareholders.

Shareholder Yields

Main Street Value Investor considers a company's returns to shareholders a leading barometer of the worthiness of owning a slice of that business.

Earnings Yield

Earnings yield is the annualized trailing EPS divided by the most recent stock closing price. We view earnings yield, the inverse of the price to earnings ratio [P/E], as the equivalent of a stock's equity bond rate or how a company's earnings compare to the 10-year Treasury rate, which was yielding 2.66% as of this writing.

Thus, we currently look for stocks with earnings yields exceeding 5%, or at least 300 to 400 basis points (two to three percentage points) above the 10-year Treasury yield.

Free Cash Flow Yield

Some investors trust free cash flow over earnings due to the GAAP/non-GAAP controversy surrounding earnings calculations. We prefer to analyze the returns for both as opposed to picking one over the other, as having more information about a company and its underlying stock is to our advantage. Nonetheless, keep in mind that free cash flow is a byproduct of earnings.

Free cash flow yield is trailing free cash flow per share divided by the most recent closing stock price. We consider above 7% as an ideal target as that would signal a free cash flow multiple of under 15.

Dividend Yield

Ultimately, dividends keep us compensated in the short term as we wait patiently for capital appreciation of the stock over time.

We target companies with a dividend yield or the annual dividend rate divided by the most recent stock price that is exceeding 2%.

The Magic of Compounding Protected by a Wide Margin of Safety

(Source: Steve PB/Pixabay)

As active, self-directed value investors, we are keenly aware of the risks of investing in the common stocks of publicly-traded companies. We are also on guard against sudden market exuberance - Bitcoin being the current flavor of the month - that can take down the entire market in one overzealous swoop. Remember junk bonds in the 1980s, dot-coms in the 1990s, and mortgage-backed securities in the 2000s?

In between bubbles, gyrations within the U.S. domestic stock market spurred by irrational investor sentiment from the daily news cycle and quarterly earnings releases keep our holdings on a roller coaster ride in the short-term as we wait for the compounded capital and income growth of our portfolio in the long-term.

We mitigate those risks by employing a value-oriented, long-view portfolio strategy of buying slices of wonderful dividend-paying companies at reasonable prices. We then hold our shares for as long as the company remains terrific as demonstrated by growing revenues and earnings; and, most important, by generating free cash flow and capital allocations that produce compounding annual returns for shareholders.

Returns on Management

At MSVI, we prefer highly profitable, cash-generating companies that provide margins of safety in a literal sense. We want to own companies with efficient and transparent management that leverage returns for customers, employees, and shareholders.

When considering the worthiness of a company's inclusion in the Main Street Value Investor Model Portfolio, the emphasis is placed on actual growth metrics as opposed to speculative forecasts of what may or may not occur with future revenues, earnings per share, free cash flow, or dividend growth.

In our 20+ years of active investing, we have discovered a mere handful of fundamental measures of a company that more often - although not always - predict the general direction of the forward-looking long-term performance of the underlying stock.

We think investing is simple, if not easy; doable, if not intimidating. We drown out the Wall Street noise by kissing our portfolio each market day:

K.I.S.S. - Keep Investing Super Simple

As much as the Wall Street Way may attempt to convince you otherwise, this is not rocket science, folks.

Revenue, Earnings Per Share, and Dividend Growth

When considering the worthiness of a company's inclusion in the MSVI Model Portfolio, we emphasize actual growth metrics as opposed to speculative forecasts best left to the crystal ball. As defensive investors, we prefer companies that are already growing, not just promising to grow.

We evaluate a minimum of three-year growth in revenue, earnings per share, and dividend rates. In each case, we are looking for double-digit compounded annualized growth.

Operating and Net Profit Margins

Is the company profitable? Only speculators and misinformed investors go long the stock of companies that are consistently losing money.

We take a look at the trailing 12-month operating margin (EBIT or earnings before interest and taxes divided by revenue); and net profit margin, i.e., trailing 12 months of income after taxes divided by sales.

Again, we favor double-digit top and bottom line margins or superior growth for companies in traditionally single-digit margin industries.

Return on Invested Capital

As does Buffett, we place a premium on the return on invested capital [ROIC], or how well a company is allocating its financial resources to generate returns for the business. We target companies producing 12% or higher in ROIC.

To be sure, the return on invested capital is only as good as the company's weighted average cost of that capital [WACC]. When a business's ROIC diminishes toward the underlying cost of capital, it typically translates to an inverse decrease in valuation and an increase in risk.

Return on Equity and Assets

The potential for manipulation of equity from aggressive stock buybacks notwithstanding, the return on equity - or how well the company generates net income as a percentage of total equity in the stock - provides another excellent measure of management effectiveness.

Whenever a company exhibits massive inventory and logistics management, we also want to take a peek at return on assets [ROA], i.e., management's ability to deploy its assets efficiently.

Employee Satisfaction and CEO Rating

Completing an Employee Survey (Source: Ernest O. Eslava/Pixabay)

A unique contribution of the Main Street Value Investor series is the measurement of employee satisfaction, including the rank and file's evaluation of the CEO. Although gathered from non-scientific data of the all-too-biased Internet, we believe a snapshot look at employee morale is a worthwhile attempt at quantifying a company's cultural dynamic.

Why not own quality, enduring companies regardless of who is the CEO at present? On the other hand, poor performing CEOs can produce value opportunities to buy great companies at bargain prices.

Warren Buffett also famously said:

Buy companies that are so wonderful an idiot can run them because sooner or later one will.

We seek high-quality companies with attractive long-term prospects. However, the potential for the magic of compounding on total returns is more likely when the stock exhibits a wide margin of safety at purchase.

Valuation Multiples

The potential for the magic of compounding from total returns increases dramatically when a stock is purchased with a wide margin of safety.

Determining the attractiveness of a stock's price based on valuation multiples relative to a company's fundamentals is one of the primary tenets of the Main Street Value Investor's search for stock investing nirvana or alpha.

However, we rely on just three multiples that we think are the best measurements of mispricing: market sentiment, revenue, and cash flow.

Enterprise Value to Operating Earnings

EV/EBITDA is enterprise value [EV], i.e., total market value and debt less cash, as it relates to operating earnings or earnings before interest, taxes, depreciation, and amortization [EBITDA]. In general, less than 12 times reflects a reasonable stock price.

EV/EBITDA is a useful indicator of whether the stock is overbought or oversold by the market.

Price to Sales

(Source: Geralt/Pixabay)

We interpret <2.00x as an attractive multiple when measuring a stock price relative to its revenue stream.

Price to Operating Cash Flow

We also measure cash flow multiples as a reliable predictor of the intrinsic value of a stock price. We look for stocks trading at a single-digit multiple to the organization's operating cash flow (P/CF).

Price to Earnings Growth

The price to earnings growth ratio [PEG] is a favorite among Wall Street's growth and momentum crowds. As value investors, we are more cautious based on the projected nature of PEG as opposed to actual trailing results. Nonetheless, it can provide a substantive peek into a stock's price worthiness. We prefer a PEG ratio below 2.00.

Value Matters

An ever ascending bull market tests the thoughtful, disciplined, and patient value investor as bargains become scarce. Those who compromise and join the herd in scooping up overpriced growth stocks or poor quality value traps on the fear of missing out - aka FOMO syndrome - usually regret the purchases when the market ultimately retreats.

I experienced FOMO in 2007 and have thus learned first-hand from experience that it doesn't work. You can bet on one thing: this time will NOT be different, and quality bargains will once again abound for the disciplined and patient investor flush with FDIC-insured cash. When will that happen? I have no idea and dismiss any expert predictions on market trends, stock prices, and interest rate movements as no more dependable than the Ouija board (HAS).

I remain steadfast that holding only the stocks of quality companies outperforms the roller coaster movements of the markets over time. And the partial ownership of great companies gives us the sense of directly contributing to socioeconomic opportunities for our family, country, and the world.

To the contrary, trading stocks and currencies on speculation in the quest for fast money is fleeting, and the house usually wins those bets anyhow.

Downside Risk

For value investors, an attractive current stock price is a non-negotiable prerequisite to initiating the productive partial ownership of a quality company. However, preservation of capital becomes supreme immediately following the stock purchase. Thus, evaluating downside risk is a useful, if not required, measurement of the all-encompassing margin of safety.

Economic Moat

In investment terms, an economic moat is the subjective measurement of the competitive advantages of a company's products or services in the marketplace, thus creating a barrier to entry for potential competitors. The stock prices of publicly-traded corporations that are surrounded by wide economic moats tend to have higher floors in down markets.

Price Volatility

Beta or the fluctuation of a stock price to changes in the overall market is a controversial measure of a stock's volatility, but we look at three-year trailing beta to see how movements in the stock price measure up to the market's current volatility, or lack thereof.

As the benchmark, the market assigns the S&P 500 a perpetual beta of 1.00. Despite a low volatility market climate at present, we still contemplate beta in our research. Three to five-year beta below 1.25 or no more than 25% volatility to the benchmark is preferred. Less than 1.00 is ideal.

Short Interest as a Percentage of the Float

The short interest as a percentage of the float is the ratio of tradeable common shares sold short, i.e., a bet that the stock price is poised to drop based on decaying fundamentals, high valuation multiples, or negative catalysts. Our favorite investment tongue-twister:

Shorts in time are left short and then cover their shorts.

We typically don't worry about the market plundering a stock if the short interest is below 5% of the float.

Long-term Debt Coverage

A company's long-term debt coverage, e.g., current assets divided by long-term debt [CA/LTD], was a favorite of Benjamin Graham, the father of value investing. Higher than 1.50 is ideal, as we want to own businesses that theoretically can pay down debt at least one and a half times using liquid assets.

In simple terms, the company should be able to pay off its long-term debt obligations using liquid assets such as cash and equivalents, short-term investments, accounts receivables, and inventories.

Short-term Debt Coverage

We also measure short-term debt coverage via current ratio [CR], another simple but telling measure of a company's financial stability. CR is current assets divided by current liabilities, thus the higher above 1.00, the better.

We avoid overly leveraged companies that are carrying debt that is more than double the outstanding equity.

Just like financially troubled households that carry debt twice their net worth, the same holds true for most companies. Using debt in a low-interest rate environment is judicious; leveraging too far beyond net worth or net asset value is a recipe for disaster waiting for the first signs of a market downturn or economic recession to cook the books.

The good times are euphoric until they are not.

Market Risk

(Source: Pixabay)

As active, self-directed value investors we want to be keenly aware of the perils of investing in the common shares of publicly-traded companies.

We assign an overall market risk profile of high, above average, average, below average, or low to each stock researched. We more often purchase shares with below average or low-risk profiles that also meet our criteria for value proposition, shareholder yields, returns on management, and valuation multiples.

We mitigate any underlying risks by employing a value-oriented, long view portfolio strategy of buying slices of wonderful, dividend-paying companies at reasonable prices. We then hold our shares for as long as the company remains terrific as demonstrated by growing revenues and earnings; and, more importantly, by generating free cash flow and capital allocations that produce compounding annual returns for shareholders.

Build and Maintain Wealth with a Wide Margin of Safety

(Source: Dawn Fu/Pixabay)

This over-extended bull market, including the unpredictable gyrations forced by the irrational sentiment of traders and speculators, is another reminder to stay invested in the stocks of companies with compounding dividends and capital gains protected by wide margins of safety.

As you patiently search for bargains to add to your portfolio and find that new opportunities are temporarily non-existent, you are better off just staying put.

And remember that the good ideas already sitting in your portfolio may be the best opportunities to invest dry powder as opposed to speculative or desperate new ideas.

Believing that the current business cycle is somehow different, investors are playing the fool's game by chasing the perceived fast money of trend following, momentum growth trading, cryptocurrency, and other speculative fads of the moment that put the herd's penchant for irrational behavior in full gear.

To the contrary, thoughtful, disciplined, and patient investors do not practice FOMO. Instead, he or she exercises the more practical FOLM or the fear of losing money. Because protecting our hard-earned principal is priority number one.

In our view, the pursuit of alpha equates to a portfolio of dividend-paying common stocks of quality companies outperforming the S&P 500 benchmark over time, plus exceeding any other expectations we have placed on ourselves as disciplined, long-view investors.

Although arguably the most challenging aspect of the investment paradigm, practicing patience, is paramount to portfolio success as we wait for our investment theses to play out.

Patience is the scarcest commodity on Wall Street.

We accomplish alpha by researching fundamentally sound companies that are trading at reasonable valuations and demonstrating the propensity for downside protection of capital invested, or margin of safety.

We then patiently wait through market and company gyrations for our thesis on the stock to play out over a long-term holding period.

Post-Script

If you have gotten this far in a rather comprehensive article, I acknowledge your patience and commitment to value investing. Granted, some readers may have stopped reading earlier in the article, if at all, assuming value investing is dead.

I address the utter misnomer in my widely read and commented article on Seeking Alpha, On The Death Of Value Investing.

But what do I know? Well, I do know that many of the most successful investors of all time are self-proclaimed value-oriented investors: Benjamin Graham, Warren Buffett, Charlie Munger, Sir John Templeton, Peter Lynch, William Browne, Charles Royce, Martin Whitman, Seth Klarman, Stephen Mandel, Howard Marks, Walter Schloss, Joel Greenblatt, Mario Gabelli, Michael Price, David Einhorn, Bill Miller, and Daniel Loeb to name a few legends.

These value investor household names remind us that the practice of owning stocks of quality companies with wide margins of safety at the time of purchase is as enduring as rock and roll, electricity, and that the earth is indeed round.

To be sure, anything worthwhile, including value investing, has its lapses in popularity or methods of delivery but inevitably evolves and perseveres.

That written, we believe there is no equal to value investing for the self-directed investor that strives to build and maintain an enduring portfolio that finances the indispensable milestones in the lives of his or her loved ones, whether a college education, a home, a hobby, a business, a wedding, or retirement.

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

Additional disclosure: An advance reader copy of this article was posted on January 23, 2018, for members of Main Street Value Investor on Marketplace before its submission to the Seeking Alpha editorial team. Data is for illustrative purposes only. The accuracy of the data cannot be guaranteed. Narrative and analytics are impersonal, i.e., not tailored to individual needs or intended for portfolio construction beyond the contributor’s model portfolio which is presented solely for educational purposes. David J. Waldron is an individual investor and author, not an investment adviser. Readers should always engage in further research and consider (as appropriate) consulting a fee-only certified financial planner, licensed discount broker/dealer, flat fee registered investment adviser, certified public accountant, or qualified attorney before making any investment, income tax, or estate planning decisions.