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August 19 2012| Filed Under Financial Theory, Fundamental Analysis,
Investment, Volatility, Warren Buffett
When investing, it is well accepted that one of the main things you should
focus on is risk. However, modern investment theory mainly focuses on the
volatility of an asset in its treatment of risk. The margin of safety theory is
a little different - it argues that downward spikes of volatility make stocks
less risky. This is an important concept to grasp in depth, because common risk
theories can lead to missed opportunities. Investing gurus Benjamin Graham and
Warren Buffett were instrumental in developing margin of safety. Read on to
find out how this theory helped propel their portfolios to meteoric heights.
SEE: Beta: Gauging Price Fluctuations
Beta's Misgivings
In general, people do not like surprises. More precisely, people do not like
adverse surprises. Because investors are assumed to be more averse to losing
money than gaining it, modern investment theory views the volatility of an
asset, as measured by its beta, as the main component of risk. The theory
implies that investors should pay less for an asset with a higher beta.
One problem with beta is that it implies that if an asset's value suddenly
drops, even due to irrational market behavior, that it becomes more risky
because it will have a higher beta. We'll poke some holes in this view in
moment, using an example from Warren Buffett.
An Alternate Strategy of Risk
Introduced by the father of value investing, Benjamin Graham, and notably
implemented by Warren Buffett, margin of safety was presented as a different
view of risk and how to protect against it. Graham's concept is not new. He
first presented his investing style with David Dodd in 1934's "Security
Analysis" and later with his more accessible book, "The Intelligent Investor",
which was first published in 1949.
Graham characterized volatility as "Mr. Market" coming each day to buy from you
or sell to you. Graham hoped to buy assets that Mr. Market would sell to him
with a 50% margin of safety. This, essentially, would be like trying to buy a
dollar for $0.50.
Graham discussed how companies all have an intrinsic measurable value. When
Graham first pitched and practiced this idea, information on companies was not
nearly as easy to access. He would search through the financial statements and
look for what he called net-nets, or companies trading below their liquidation
values.
Graham would take a company's current assets with considerable deductions, and
subtract all of the liabilities on the balance sheet. At its heart, Graham's
net-net investing is the most conservative value approach, and involves very
little risk if done right.
Example - Finding A Company's Net-Net
ABC Company has the following balance sheet and market capitalization:
Cash $250
Cash Equivalents $50
Accounts Receivable (A/R) $100
Inventories $100
Total Liabilities $300
Share Price $62.50
Cash and cash equivalents are good to go, we have $300 there. Next, we turn to
A/R, some of which will not be paid. Usually we have a net A/R number on the
balance sheet, indicating the amount of receivables the company expects to
recover. If we have it, this net number is based on the company's history of
collecting receivables, and is a good indicator, but we would still discount it
a little for added safety.
In this scenario, we have a gross A/R number. Again we don't expect to recover
it all, but ABC is known to have a fairly reliable client base and we could
easily anticipate recovering around 80% of A/R - to be even more conservative
we will only factor in recovering 75%. Many investors may want to take a look
at the company's allowance for doubtful accounts in their financial statements
as a method for gauging an accurate recovery percentage, but in this case,
we'll value A/R at $75 ($100 x 0.75). Finally, there is ABC's inventory. ABC
has competitors, which we could assume, at the very least, would buy the
inventory for half its value. So we take the inventory's value at $50 ($100 x
0.5).
We end up with marked down current assets of $425 ($300 + $75 + $50), and total
liabilities of $300. This net-net is worth $125 ($425 - $300), not even
accounting for any real estate or other long-term assets the company might
have. With the company selling at only $62.50 in the market, this is a net-net
with a 50% margin of safety. Paying half of a company's net-net value was
Graham's goal, and at most, he would pay two-thirds of a company's net-net
value, for a 33% margin of safety. In our example, we have a 50% buffer between
the market value of the company and our conservative valuation of the company's
current assets. By only buying at a steep discount to our valuation, this
margin of safety provides its own built-in measure against the risk of mistakes
in our calculations.
Let Volatility Be Your Friend
This process of investing did not guarantee success, but with research and hard
work, finding one of these scenarios was about as close to a sure thing as you
could get. A lot has changed, and Graham's net-nets have essentially
disappeared in the modern market. With the quick and widespread dissemination
of information, markets have become somewhat more efficient.
While net-nets are disappearing, investors can see that the market provides
sales on assets quite often. The concept of buying companies with an adequate
margin of safety still remains, and has been practiced with great success by
many value investors, most notably Warren Buffett.
Example - Taking the Value of Long-Term Assets Into Account
In the ABC example, we gave absolutely no value to the company's long term
assets. Let's return to the example and suppose that that the company's share
price is now at $200. We calculated its net-net worth at $125, so according to
that it would not be a good value, but we note that ABC also has the following
assets on its books:
Plant, Property, & Equipment $200
Long-Term Bonds $100
We notice from some research that the plants on the company's balance sheet
have likely appreciated because property values have gone up in that area.
However, we will remain very conservative in this example and still value it at
$200. Next, with the company's long-term bonds, we may worry about the market
value if the bonds need to be sold quickly. We will only accept 75% of the
value, and value the bonds at $75 ($100 x 0.75). We end up with an asset value
of $400 (net-net worth of $125 + $200 + $75). Again, we can buy the stock of
this company with a 50% margin of safety at its current market price of $200.
This again seems like a home run of an investment. We are still being
conservative, and we ignored any assets that could be off ABC's books, such as
the appreciated value of its real estate. Other hidden assets are brands,
exceptional management, competitive advantages, etc. There is much to be said
about the market value of hidden assets, but the point will remain the same.
Don't Run From Beta
Now looking strictly at beta, let's say ABC had a beta of 1.5. After all of our
work, we decide to go to bed and buy tomorrow. However, the next day, "Mr.
Market" decides to take the price of ABC down to $150, while the rest of the
market stays pretty flat. This sharp 25% decline in ABC stock makes it riskier
according to beta.
However, according to Warren Buffett in his 1993 letter to shareholders this
altered perception of risk is misleading:
"Under beta-based theory, a stock that has dropped very sharply compared to the
market - as had Washington Post when we bought it in 1973 - becomes "riskier"
at the lower price than it was at the higher price. Would that description have
then made any sense to someone who was offered the entire company at a
vastly-reduced price?"
What this means is that volatility is our friend in this scenario. We did the
work to value the company, and now Mr. Market is just offering it to us at a
steeper discount and a higher margin of safety. If we had already made the
purchase before the decline, we might kick ourselves for bad timing, but
according to our research, an investment in ABC is still worth much more than
what we paid.
Take a Page From the Masters
The concept of margin of safety as practiced by Warren Buffett is not that
complicated. These are fairly simple ideas, and should teach us all not to rely
simply on volatility as a judge of risk. Many common theories of risk make
volatility out to be a bad thing, and if a stock's sea becomes choppy, some
investors may sail for calmer waters. But take a cue from Warren Buffett. He,
and other value investors, get excited in volatile and down markets. If you
invest carefully, and with an adequate margin of safety, Mr. Market's mood
swings can lead to great opportunities.
by Wayne Pinsent