Benjamin Graham's Margin of Safety: Protecting Investments with a Buffer, Study notes of Business

Download Benjamin Graham's Margin of Safety: Protecting Investments with a Buffer and more Study notes Business in PDF only on Docsity! Ben Graham’s Margin of Safety Principle Page 1 Chapter 20: “Margin of Safety” as the Central Concept of Investment by Benjamin Graham 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. 1 This is the thread that rounds through all the preceding discussion of investment policy--often explicitly, sometimes in a less direct fashion. Let us now, briefly, to trace that idea in a connected argument. All experienced investors recognize that the margin of safety concept is essential to the choice of sound bonds and preferred stocks. For example, a railroad should have earned its total fixed charges better than five times (before income tax), taking a period of years, for its bonds to qualify as investment-grade issues. This past ability to earn in excess of interest requirements constitutes the margin of safety that is counted on to protect the investor against loss or discomfiture in the event of some future decline in net income. (The margin of above charges may be stated in other ways—for example, in the percentage by which revenues or profits may decline before the balance after interest disappears—but the underlying idea remains the same.) The bond investor does not expect future average earnings to work out the same as the in the past; if he were sure of that, the margin demanded might be small. Nor does he rely to any controlling in his judgment as to whether future earnings will be materially better or poorer than in the past, if he did that, he would have to measure his margin in terms of a carefully projected income account, instead of emphasizing the margin shown in the past record. Here the function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future. If the margin is a large one, then it is enough to assume that future earnings will not fall far below those of the past in order for an investor to feel sufficiently protected against the vicissitudes of time. The margin of safety for bonds may be calculated, alternatively, by comparing the total value of the enterprise 2 with the amount of debt. (Ditto for preferred stock issue) If the business owes $10 million and is fairly worth $30 million, there is room for a shrinkage of two-thirds in value—at least theoretically—before the bondholders will suffer loss. The amount of this extra value, or “cushion,” above the debt may be approximated by using the average market price of the junior stock issues over a period of years. Since average stock prices are generally related to average earning power, the margin of “enterprise value” over debt and the margin of earnings over charges will in most cases yield similar results. So much for the margin-of-safety concept as applied to “fixed-value investments.” Can it be carried over into the field of common stocks? Yes, but with some necessary modifications. There are instances where a common stock may be considered sound because it enjoys a margin of safety as large as that of a good bond. This will occur, for example, when a company has outstanding only 1 Buffett has been quoted as saying these three words (Margin of Safety) are the most important concept in investing. Your mindset is important. The investor allows for being wrong; for having a margin of error built into his/her process. Don’t drive a 9,000 pound truck over a bridge built to hold 10,000 pounds, drive a 5,000 pound truck. 2 Graham means total enterprise value or (fully diluted shares outstanding x price) plus market value of all debt minus excess cash not used for operations. Ben Graham’s Margin of Safety Principle Page 2 common stock that under depression conditions is selling for less than the amount of bonds that could safely be issued against it property and earning power 3 . That was the position of a host of strongly financed industrial companies at the low price levels of 1932-33. In such instances the investor can obtain the margin of safety associated with a bond, plus all the chances of larger income and principal appreciation inherent in a common stock. (The only thing he lacks is the legal power to insist on dividend payments “or else”—but this is a small drawback as compared with his advantages.) Common stocks bought under such circumstances will supply an ideal, through infrequent, combination of safety and profit opportunity. As a quite recent example of this condition, let us mention once more National Presto Industries Stock, which sold of a total enterprise value of $443 million in 1972. With its $16 million of recent earnings before taxes the company could easily have supported this amount of bonds. In the ordinary common stock, brought for investment under normal conditions, the margin of safety lies in an expected earning power considerably above the going rate for bonds. In former editions we elucidated these points with the following figures: Assume in a typical case that the earning power is 9% on the price and that the bond rate is 4%; then the stock buyer will have an average annual margin of 5% accruing in his favor. Some of the excess is paid to him in the dividend rate; even though spent by him, it enters into his overall investment result. The undistributed balance is reinvested in the business for his account. In many cases such reinvested earnings fail to add commensurately to the earning power and value of his stock. (That is why the market has a stubborn habit of valuing earnings disbursed in dividends more generously than the portion retained in the business.)* But, if the picture is viewed as a whole, there is a reasonably close connection between the growth of corporate surpluses through reinvested earnings and the growth of corporate values. Over a ten-year period the typical excess of stock earning power over bond interest may aggregate 450% of the price paid. This figure is sufficient to provide a very real margin of safety—which, under favorable conditions, will prevent or minimize a loss. If such a margin is present in each of a diversified list of twenty or more stocks, the probability of a favorable result under “fairly normal conditions” becomes very large. That is why the policy of investing in representative common stocks does not require high qualities of insight and foresight to work out successfully. If the purchases are made at the average level of the market over a span of years, the prices paid should carry with them assurance of an adequate margin of safety. The danger to investors lies in concentrating their purchase in the upper levels of the market, or in buying non-representative common stocks that carry more than average risk of diminished earning power. As we see it, the whole problem of common-stock investment under 1972 conditions lies in the fact that “in a typical case” the earning power is now much less than 9% on the price paid. 4 Let us assume that by concentrating somewhat on the low-multiplier issues among the large companies a defensive investor may now acquire equities at 12 times recent earnings—i.e., with an earnings return of 8.33% on cost. He may obtain a dividend yield of about 4%, and he will have 4.33% of his cost reinvested in the business 3 “Earning power” is Graham’s term for a company’s potential profits or, as he puts it, the amount that a firm “might be expected to earn year- after-year if the business conditions prevailing during the period were to continue unchanged” (Security Analysis, 1934 ed., p 354). Some of his lectures make it clear that Graham intended the term to cover periods of five years or more. You can crudely approximate a company’s earning power per share by taking the inverse of its P/E ratio; a stock with a P/E ratio of 11 can be said to have earning power of 9 or 1 divided by 11. 4 Graham elegantly summarized the discussion that follows in a lecture he gave in 1972: “The margin of safety is the difference between the percentage rate of the earnings on the stock at the price you pay for it and the rate of interest on bonds, and that margin of safety is the difference which would absorb unsatisfactory developments. At the time the 1965 edition of the Intelligent Investor was written, the typical stock was selling at 11 times earnings, giving about 9% return as against 4% on bonds. In that case you had a margin of safety of over 100 per cent. Now in 1972 there is no difference between the earnings rate on stocks and the interest rate on stocks and I say there is no margin of safety…you have a negative margin of safety on stocks…. Ben Graham’s Margin of Safety Principle Page 5 between the concepts of investment and of speculation. We think this skepticism is unnecessary and harmful. It is injurious because it lends encouragement to the innate leaning of many people toward the excitement and hazards of stock-market speculation. We suggest that the margin of safety concept may be used to advantage as the touchstone to distinguish an investment operation from a speculative one. Probably most speculators believe they have the odds in their favor when they take their chances, and therefore they may lay claim to a safety margin in their proceedings. Each one has the feeling that the time is propitious for his purchase, or that his skill is superior to the crowd’s, or that his adviser or system is trustworthy. But such claims are unconvincing. They rest on subjective judgment, unsupported by any body of favorable evidence or any conclusive line of reasoning. We greatly doubt whether the man who stakes money on his view that the market is heading up or down can ever be said to be protected by a margin of safety in any useful sense of the phrase. By contrast, the investor’s concept of the margin of safety—as developed earlier in this chapter—rests upon simple and definite arithmetical reasoning from statistical data. We believe, also that it is well supported by practical investment experience. There is no guarantee that this fundamental quantitative approach will continue to show favorable results under the unknown conditions of the future. But, equally, there is no valid reason for pessimism on this score. Thus, in sum, we say that to have a true investment there must be present a true margin of safety. And a true margin of safety is one that can be demonstrated by figures, by persuasive reasoning, and by reference to a body of actual experience. EXTENSION OF THE CONCEPT OF INVESTMENT To complete our discussion of the margin of safety principle we must now make a further distinction between conventional and unconventional investments. Conventional investments are appropriate for the typical portfolio. Under this heading have always come United States government issues and high grade, dividend paying common stocks. We have added state and municipal bonds for those who will benefit sufficiently by their tax-exempt features. Also included are first-quality corporate bonds when, as now, they can be bought to yield sufficiently more than United States saving bonds. Unconventional investments are those that are suitable only for the enterprising investor. They cover a wide range. The broadest category is that of undervalued common stocks of secondary companies, which we recommend for purchase when they can be bought at two thirds or less of their indicated value. Besides these, there is often a wide choice of medium grade corporate bonds and preferred stocks when they are selling at such depressed prices as to be obtainable also at a considerable discount from their apparent value. In these cases the average investor would be inclined to call the securities speculative, because in his mind their lack of a first-quality rating is synonymous with a lack of investment merit. 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 create a substantial margin of safety, the security thereby meets out criterion of investment. Our favorite supporting illustration is taken from the field of real estate bonds. In the 1920s, billions of dollars’ worth of these issues were sold past par and widely recommended as sound investments. A large proportion had so little margin of value over debt as to be in fact highly speculative in character. In the depression of the 1930’s an enormous quantity of these bonds defaulted their interest, and their price collapsed—in some case below 10 cents on the dollar. At that stage the same advisors who had recommended them at par as Ben Graham’s Margin of Safety Principle Page 6 safe investments were rejecting them as paper of the most speculative and unattractive type. But as a matter of fact the price depreciation of about 90% made many of these securities exceedingly attractive and reasonable safe—for the stated values behind them were four or five times the market quotation* *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 worse company is worth buying if its stock goes low enough. (James Grant of Grant’s Interest Rates Observer says there are no bad bonds just bad bond prices). A company may be a great investment when its stock price is depressed relative to its normal earnings power and asset values while becoming a terrible investment at another high price of its stock. Look at the lesson of the “Nifty Fifty” from the Go- Go years of the late 1960s and early 1970s. Those high quality companies like Avon, IBM, P&G became one decision stocks to be held forever even at absurdly high prices. This concept was crushed during the bear market of 1973/1974 when stock prices of those companies declined 50% to 80%. The fact that the purchase of these bonds actually resulted in what is generally called “a large speculative profit” did not prevent them from having true investment qualities at their low prices. The “speculative” profit was the purchasers’ reward for having made an unusually shrewd investment. They could properly be called investment opportunities, since a careful analysis would have shown that the excess of value over price provided a large margin of safety. Thus the very class of “fair weather investment” which we stated above is a chief source of serious loss to naïve security buyers is likely to afford many sound profit opportunities to the sophisticated operator who may buy them later at pretty much his own price. (The very people who considered technology and telecommunication stocks a “sure thing” in late 1999 and early 2000,when they were hellishly overpriced, shunned them as “too risky: in 2002—even though, in Graham’s exact words from an earlier period, “the price depreciation of about 90% made many of these securities exceedingly attractive and reasonably safe. 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. The whole field of “special situations” would come under our definition of investment operations, because the purchase is always predicted on a thoroughgoing analysis that promises a larger realization than the price paid. Again there are risk factors in each individual case, but these are allowed for in the calculations and absorbed in the overall results of a diversified operation. To carry this discussion to a logical extreme, we might suggest that a defensible investment operation could be set up by buying such intangible values as are represented by a group of “common stock option warrants” selling at historically low prices. (This example is intended as somewhat of a shocker.) 6 The entire value of these warrants rests on the possibility that the related stocks may some day advance above the option price. At the moment they have no exercisable value. Yet, since all investment rests on reasonable future expectations, it is proper to view these warrants in terms of the mathematical chances that some future bull market will create a large increase in their indicated value and in their price. Such a study might well yield the conclusion that there is much more to be gained in such an operation than to be 6 Graham uses “common stock option warrant” as a synonym for “warrant,” a security issued directly by as corporation giving the holder a right to purchase the company’s stock at a predetermined price. Warrants have been almost entirely superseded by stock options. Graham quips that he intends the example as a “shocker” because, even in his day, warrants were regarded as one of the market’s seediest backwaters. Ben Graham’s Margin of Safety Principle Page 7 lost and that the chances of an ultimate profit are much better than those of an ultimate loss. If that is so, there is a safety margin present even in this unprepossessing security form. A sufficiently enterprising investor could then include an option-warrant operation in this miscellany of unconventional investments. 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.” (circle of competence). For the investor this means: Do not try to make “business profits” out of securities—that is, returns in excess of normal interest and dividend income—unless you know as much about security values as you would need to know about the value of merchandise that you proposed to manufacture or deal in. A second business principle: “Do not let anyone else run your business, unless (1) you can supervise his performance with adequate care and comprehension or (2) you have unusually strong reasons for placing implicit confidence in his integrity and ability.” For the investor this rule should determine the conditions under which he will permit someone else to decide what is done with his money. A third business principle: “Do not enter upon an operation—that is, manufacturing or trading in an item—unless a reliable calculation shows that it has a fair chance to yield a reasonable profit. In particular, keep away from ventures in which you have little to gain and much to lose.” For the enterprising investor this means that his operations for profit should be based not on optimism but on arithmetic. For every investor it means that when he limits his return to a small figure--as formerly, at least, in a conventional bond or preferred stock—he must demand convincing evidence that he is not risking a substantial part of his principal. A fourth business rule is more positive: “Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it—even though others may hesitate or differ.” (You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.) Similarly, in the world of securities, courage becomes the supreme virtue after adequate knowledge and a tested judgment are at hand. Fortunately for the typical investor, it is by no means necessary for his success that he bring these qualities to bear upon his program—provided he limits his ambition to his capacity and confines his activities with the safe and narrow path of standard, defensive investment. To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks. -