Thursday, April 7, 2016

A Margin of Safety Boosts Returns Rather than Just Providing Protection

Value investing or dividend investing may often be thought of as conservative investing methods, and this may be true in many cases. But the purpose of a margin of safety is not just to protect your rate of return, but indeed to improve it.
When you buy a stock below calculated fair value, an expectation is that in some future time, the stock price will go back up to fair value in a rational market. If your growth expectations end up being correct, and you bought at an undervalued price, then you should eventually get a superior rate of return.
Alternatively, the longer the stock remains undervalued, the better it is for shareholders, because their reinvested dividends, or their new purchases, or management’s share buybacks, continue to accumulate undervalued shares. It actually becomes a demonstrably negative scenario for a long term investor when their stocks go up above fair value.

Buffett put it concisely in his 2011 shareholder letter:
Today, IBM has 1.16 billion shares outstanding, of which we own about 63.9 million or 5.5%. Naturally, what happens to the company’s earnings over the next five years is of enormous importance to us. Beyond that, the company will likely spend $50 billion or so in those years to repurchase shares. Our quiz for the day: What should a long-term shareholder, such as Berkshire, cheer for during that period?
I won’t keep you in suspense. We should wish for IBM’s stock price tolanguish throughout the five years.
Let’s do the math. If IBM’s stock price averages, say, $200 during the period, the company will acquire 250 million shares for its $50 billion. There would consequently be 910 million shares outstanding, and we would own about 7% of the company. If the stock conversely sells for an average of $300 during the five-year period, IBM will acquire only 167 million shares. That would leave about 990 million shares outstanding after five years, of which we would own 6.5%.
If IBM were to earn, say, $20 billion in the fifth year, our share of those earnings would be a full $100 million greater under the “disappointing” scenario of a lower stock price than they would have been at the higher price. At some later point our shares would be worth perhaps $1.5 billion more than if the “high-price” repurchase scenario had taken place.
The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day’s supply.
That’s how Buffett made 30-50% returns in his early days. He wasn’t investing in companies that were growing earnings by 30-50% per year; he was investing in companies that were seriously undervalued. Eventually, those stocks will return to normal values, and the longer they don’t, the better it is for the investor.
(Note: Rather than picking large caps like IBM, he was a deep value investor, finding huge mismatches between price and value. As his base of capital grew, it was no longer economical for him to invest in small companies and he either had to buy whole companies or invest primarily in large caps that either have GARP or dividend growth characteristics.)
Check the article tomorrow for an example illustration of the concept.
This article was written by Dividend Monk. If you enjoyed this article, please subscribe to my feed [RSS]


Post a Comment

Recent Posts From DIV-Net Members