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Invest In Stocks With A Margin of Safety To Reduce Risk And Enhance Returns

Of all of the many sound investing principles that legendary teacher and investor Ben Graham put forward, he believed that his concept of “margin of safety” was the most important of all.  This investment lesson was so deeply ingrained into the mind of Ben Graham’s most famous student, Warren Buffett, that he created his two most important rules of sound investing.  Rule number one: Never lose money.  Rule number two: Never forget rule number one.  Clearly, both of these renowned sages understood the importance of minimizing risk, especially when investing in equities.  The following quote from Ben’s famous book The Intelligent Investor corroborates and summarizes my point:

“In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, This too will pass.”* Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY. This is the thread that runs through all the preceding discussion of investment policy—often explicitly, sometimes in a less direct fashion.”  Chapter 20: The Intelligent Investor.
Investors at all levels of skill and experience will intuitively accept and embrace the margin of safety concept.  However, not all investors will dutifully follow it, but few could argue against its validity.  Moreover, those that would reject the concept will often rationalize their not following of this simple, yet profoundly important rule based on another widely-held notion that in order to get higher returns, you must simultaneously be willing to take on more risk. 
One of my primary objectives with writing this article is to turn this last notion on its head.  I intend to demonstrate that one of the most salient features of Ben Graham’s motto, MARGIN OF SAFETY, is that it not only reduces downside risk when investing in equities, but how it also simultaneously enhances future returns.  Lowering risk, while concurrently increasing return, is a fundamental tenet, and automatic benefit, of investing in a common stock when it provides the investor a large margin of safety.  Yes, investing in a stock when it offers a margin of safety undeniably lowers risk and presents the opportunity for enhanced long-term return.
In order to understand how this works, it’s implicit that we also understand exactly what a margin of safety is and means.  Simply stated, a common stock offers a margin of safety when it can be purchased at a valuation that is lower than its intrinsic value.  Moreover, the wider the gap between current value and intrinsic value, the greater will be the margin of safety.  Regarding investing in a stock when it offers a large margin of safety, some may find this next reality ironic. This also means that the safer the stock is, the greater the potential for higher future rewards it offers.  Achieving a higher return, while taking less risk, is nirvana for common stock investors.
At this point, some clarity is in order.  The margin of safety principle relates to investing in the same individual stock at different levels of valuation.  In other words, I am addressing the risk reward ratio of investing in a single or particular company, at different levels of valuation.  Consequently, it must be understood that the company possesses the same attributes of fundamental quality, and growth potential regardless of valuation.
 Consequently, the higher the valuation, the greater will be the risk, and the lower the return that investment in the company provides.  Conversely, at low valuations, the risk of owning the company is lower, but the potential future return higher.  Although this defies the principle that you must take higher risk in order to get a higher return, when investing in common stocks it represents an indisputable truth.
Margin of Safety: What It Is and How It Works
At this point, it is important to state that margin of safety is a value investor’s concept.  Moreover, it defies the conventional definition or concept of risk as defined by Modern Portfolio Theory (MPT). 
Practitioners of MPT rely heavily on the concept of beta to define risk.  The following Warren Buffett quote on beta summarizes both of our views on beta:
“Value investors scorn the idea of beta because it implies that a stock that has fallen sharply in value is more risky than it was before it fell. A value investor would argue that a company represents a lower-risk investment after it falls in value.”
Since a picture is worth a thousand words, I will provide a few examples utilizing the F.A.S.T. Graphs, Fundamentals Analyzer Software Tool to illustrate the value investor’s concept of margin of safety, and how it simultaneously reduces risk and enhances return.  The reader should further note, that what follows are simply offered as examples of how the margin of safety concept works.  Additionally, I will provide two examples of classic dividend growth stocks, and two examples of aggressive pure growth stocks to illustrate how this concept universally applies.
As an interesting sidebar, all of the following examples will illustrate what I believe to be a great irony of investing.  In reality, based on the entire historical precedent throughout all market history, the very best time to buy common stocks is when people dislike them the most.  And of course, I am referring to recessions which represent periods when people not only dislike stocks, they also flee them.  Once again I turn to Ben Graham’s The Intelligent Investor to provide insight into the fallacy behind this thinking.  The following is found in the footnotes of Chapter 20 on Pages 521 and 522:
“Graham is saying that there is no such thing as a good or bad stock; there are only cheap stocks and expensive stocks. Even the best company becomes a “sell” when its stock price goes too high, while the worst company is worth buying if its stock goes low enough.”
“Similarly, Wall Street’s analysts have always tended to call a stock a “strong buy” when its price is high, and to label it a “sell” after its price has fallen—the exact opposite of what Graham (and simple common sense) would dictate. As he does throughout the book, Graham is distinguishing speculation—or buying on the hope that a stock’s price will keep going up—from investing, or buying on the basis of what the underlying business is worth.”
Sample Dividend Growth Stocks
Aflac Inc.: (AFL)
My first example looks at what happened to Aflac’s stock price (the black line) as we entered the Great Recession of 2008-2009.  Notice how earnings, the orange line on the graph, held up much better than the stock price.  More plainly stated, the price fell far more than fundamentals justified that it should.  Therefore, once Aflac’s stock price fell below the orange earnings justified value line (intrinsic value) a clear margin of safety was created.  Moreover, the farther it fell, the safer it became while simultaneously the reward for investing in Aflac also was enhanced.
Additionally, notice that for all the years prior to that, including the recession of 2001, Aflac’s price had never fallen below its intrinsic value (the orange line).  And perhaps even more importantly, notice that Aflac raised their dividend every year (the pink line on the graph plots dividends).  Also, the reader should further realize that at Aflac’s low price of $10.83 in the spring of 2009, it provided the astute investor approximately a 10% current dividend yield.  
Therefore, at exactly the same time that Aflac’s stock provided the highest margin of safety, it also provided the highest current yield of 10.34%, and the highest future capital gain potential than at any other time.  In other words, Aflac offered investors both its highest capital gain potential, and an extremely high current yield, at precisely the safest time you could have invested in it in modern history.
A deeper look into Aflac’s fundamentals provides additional evidence as to just how safe investing in Aflac was when its margin of safety was the highest.  The following FUN Graph (fundamental underlying numbers) plots Aflac’s cash per share (cashps) and more importantly as it relates to dividends, free cash flow per share (fcsflps). FUN Graphs calculates free cash flow after dividends have been paid.  Therefore, even during the throes of the Great Recession, Aflac’s finances were healthy and strong.
3M Co.: (MMM)
Although some could argue that since Aflac is in the Financial Sector, risk, or at least the perception of risk, would be higher than my rhetoric implies.  3M on the other hand is widely considered one of the bluest of all blue chips.  Therefore, as the following Earnings and Price Correlated graph depicts, the margin of safety principle is clearly evident.
Just like we saw with Aflac, 3M offered its highest yield and simultaneously its greatest capital gain potential at precisely the time when its margin of safety was strongest.  Stated more plainly, 3M offered investors its best returns when the risk with investing in it was at its lowest level.
With my 3M example, I provide the following FUN Graph which plots assets per share (atps) and common equity per share (ceqps) also known as book value.  Once again we see an example of a company that was and remained fundamentally healthy prior to and right through our last two recessions.  Consequently, 3M’s price collapse in 2008 created a great margin of safety and an incredible opportunity to invest in their shares.
Before I leave my dividend growth examples and move on to pure growth, I feel it’s appropriate to add that the growing dividends provided by both of these Dividend Champions provide a type of margin of safety in their own right.  Even though the prices of these Dividend Champions may have temporarily fallen, the dividend income that their shareholders received continued to grow.
The reader should also recognize that every time a dividend is paid, their capital at risk is technically reduced.  This provides one more level of risk mitigation that a margin of safety provides.  This coincides with the famous Will Rogers quote: “I am more concerned with the return of my money than the return on my money.”  Consequently, astute investors focused on yield over price volatility, are additionally provided the emotional support needed to fight emotional risk.
High-Growth Stocks
By their very nature, high-growth stocks are rightfully considered riskier than blue-chip dividend paying stocks.  Not only do they not provide the safety net that dividends offer, they are also exposed to the difficult challenge of needing to continue growing at high rates in order to reward their shareholders.  Consequently, anything that reduces the risk of investing in high-growth stocks is a real plus.
Moreover, in order to participate in the potential high returns provided by a high-growth stock, implies that you must also typically be willing to buy them at higher than average valuations.  Where most stocks (average companies) are at fair value when their P/E hovers around a plus or minus 15, very fast-growing companies often command normal P/E’s that approximate their earnings growth rates.  Both of my following growth stock examples will illustrate this point.
LKQ Corp: (LKQ)
For those not familiar with this incredibly consistent high-growth stock, I offer the following excerpt business description courtesy of Capital IQ:
“LKQ Corporation, together with its subsidiaries, provides replacement parts, components, and systems needed to repair vehicles, primarily cars and trucks in the United States, the United Kingdom, Canada, Mexico, and Central America. The company operates through Wholesale—North America, Wholesale—Europe, and Self Service. It distributes various products, including aftermarket collision and mechanical products; recycled collision and mechanical products; and refurbished collision replacement products, such as heels, bumper covers and lights, and remanufactured engines to collision and mechanical automobile repair industry… The company principally serves collision and mechanical repair shops, new and used car dealerships, and metal recyclers, as well as to retail customers. LKQ Corporation was founded in 1998 and is headquartered in Chicago, Illinois.”
My primary purpose behind providing this example is to point out that during the throes of the Great Recession LKQ’s P/E ratio had fallen to 15 (Note: I have added a 15 P/E overlay-the magenta line).  Therefore, this considerably above-average growth stock could then have been purchased at the valuation of an average growing business.  Moreover, notice that only price was weak during this time while earnings continued to strongly advance.  Astute growth investors are always on the lookout for this kind of opportunity.  (Note that LKQ does not offer a margin of safety at today’s high valuation).
Cognizant Technology Solutions: (CTSH)
For those not familiar with this incredibly consistent high-growth stock, I offer the following excerpt business description courtesy of Capital IQ:
Cognizant Technology Solutions Corporation provides information technology (IT), consulting, and business process outsourcing services worldwide. The company operates through four segments: Financial Services; Healthcare; Manufacturing, Retail, and Logistics; and Other. It offers consulting and technology services, such as IT strategy, program management, operations improvement, strategy, and business consulting services; and application design and development, systems integration, and enterprise resource planning and customer relationship management implementation services. It also provides enterprise information management services, such strategic, advisory, and management consulting; enterprise data management; descriptive analytics/business intelligence; strategic corporate performance management; and packaged analytics services, as well as big data services that assist clients in managing and deriving actionable insights from the explosion in the volume, variety, velocity, and complexity of data… Cognizant Technology Solutions was founded in 1998 and is headquartered in Teaneck, New Jersey.”
With Cognizant, we once again see an example of earnings continuing to strongly advance, while only fear drove stock price down.  Consequently, as we’ve seen with all of the examples cited in this article, recessions can be as much about opportunity as they are about risk.  At the end of 2008 and the beginning of 2009, this powerful growth stock could be purchased at a P/E of only 12 (Note: I have added a 12 P/E overlay-the magenta line).
The following Earnings and Price Correlated Graph since the beginning of 2009 provides an additional perspective on the margin of safety concept.  Notice that Cognizant’s earnings growth rate did slow down from 35.7% to 23.7%.  Nevertheless, the margin of safety provided by its lower-than-average valuation, mitigated the risk of slower growth.
The following performance results associated with the above Earnings and Price Correlated graph illustrate the profit opportunity afforded by investing in a high-growth stock, even when earnings growth slowed a bit.  Simply stated, buying Cognizant at a low valuation reduced risk while generating a compounded annual rate of return of 36.8% per annum that exceeded its earnings growth rate by a wide margin.
Finding A Margin Of Safety In Today’s Strong Market
At this point, I would like to address what I believe to be a very important misconception held by many investors.  Instead of predicating their stock investing decisions based on their view of the relative merits of individual companies, investors will often allow their biased view of the overall market deter them.  The refrain goes something like - after such a strong run, the stock market is now too high for me to invest in stocks.
My experience has taught me that the fallacy behind this line of thinking is that it is not a stock market; instead it is a market of stocks.  Moreover, whether we are in a bull market or a bear market, there will always be examples of overvalued, fairly valued or undervalued individual selections to be found.  Accordingly, I believe portfolios should be built one company at a time, based on the specific merits of each individual company under consideration.
Consequently, I present Deere & Co. (DE), as a current example of a quality common stock that provides a high margin of safety even in today’s supposedly overheated market.  Deere & Company is a dividend contender on David Fish’s CCC lists found here with a streak of ten consecutive years of dividend increases.  Its current single-digit P/E ratio and above-market dividend yield provides a long-term opportunity with a strong margin of safety, in my opinion.
I also offer two additional examples, Teva Pharmaceutical Industries (TEVA), and Chevron (CVX), two companies whose current low valuations also provide a strong long-term margin of safety.  Note that both of these companies can be bought at single-digit P/E ratios, which I believe mitigates any potential future weaker earnings growth.
Teva Pharmaceutical Industries
Chevron Corp
Speculation Versus Investment
The margin of safety idea conceived by Ben Graham is a concept dealing with sound investing.  Value investing, and other prudent investing strategies, must be understood in contrast to speculating.  At its heart, identifying a margin of safety in a common stock is first about identifying the company’s intrinsic business value.  Although margin of safety relates to, and with a low stock price, it is not the price per se but the valuation that it represents that is most important.  Once again, I will turn to Ben Graham’s teachings from The Intelligent Investor with two important excerpts that summarize my points.
“Margin of Safety” as the Central Concept of Investment
It is our argument that a sufficiently low price can turn a security of mediocre quality into a sound investment opportunity— provided that the buyer is informed and experienced and that he practices adequate diversification. For, if the price is low enough to create a substantial margin of safety, the security thereby meets our criterion of investment.”  Page 521 The Intelligent Investor
“To Sum Up
Investment is most intelligent when it is most businesslike. It is amazing to see how many capable businessmen try to operate in Wall Street with complete disregard of all the sound principles through which they have gained success in their own undertakings. Yet every corporate security may best be viewed, in the first instance, as an ownership interest in, or a claim against, a specific business enterprise. And if a person sets out to make profits from security purchases and sales, he is embarking on a business venture of his own, which must be run in accordance with accepted business principles if it is to have a chance of success.
The first and most obvious of these principles is, “Know what you are doing—know your business.” Page 523 The Intelligent Investor
Summary and Conclusions
Investing in common stocks is fraught with danger, complexity and confusion.  Therefore, anything that can reduce the risks associated with successfully building and executing a stock portfolio is of great benefit.  Personally, I do believe that Ben Graham’s margin of safety motto is one of the most important investing principles to keep in the forefront of our minds.  Finding stocks with great margins of safety does require some work and digging.  However, I believe the rewards are more than worth the effort.
Finally, it’s important to recognize and understand that finding stocks when they offer a margin of safety is a long-term strategy.  For whatever reason, when a stock offers a margin of safety, it is unpopular.  Therefore, logic would dictate that it may not provide immediate gratification.  However, over the long-term, which I define as at a minimum business cycle of three to five years, a stock providing a margin of safety will lower risk and increase long-term returns.  This is especially important for retired investors or those near retirement.
Disclosure:  Long AFL, LKQ, CTSH, DE< TEVA, CVX at the time of writing.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

This article was written by Chuck Carnevale. If you enjoyed this article, you can read more of his articles here.