Based on an old story, the basic issues of the world have been summarized in the sentence that (this too shall pass). If we want to compare this phrase with words that summarize investment , we will come to our shorthand word, which is (margin of safety). This is a cover that covers all the previous topics of investment policy often clearly and in some cases indirectly. Now we open this idea briefly in this topic.
What is the margin of safety in investment?
All smart investors know that the concept of margin of safety is essential to choosing bonds and preferred stocks. For example, the income of a railway company must be more than 5 times its fixed costs, which takes several years for its bonds to reach the level of investment class.
This past ability to provide surplus to requirements constitutes a margin of safety that can be relied upon to protect the investor against loss or distress caused by future reductions in net income or adverse events.
(Perhaps this work can be called the margin of expenses, for example, the percentage of reduction in income or profit before the balance of benefits is lost. It goes without saying that the idea is the same, but the expression is different.)
Application of security margin in bonds
A bond investor does not expect average future earnings to behave as they have in the past.
On the other hand, the controller does not rely on his judgment to know whether the future income is better or less than the previous income. If so, it should earn its margin accurately, according to the revenue depicted, rather than emphasizing the margin shown in the past record.
Here the application of the margin of safety is actually making an unnecessary and accurate estimate of the future. If this margin is large, then the investor has enough confidence that he has the necessary security against price fluctuations in the future.
How to calculate bond security margin
The security margin of bonds can be calculated by comparing the final value of the issuing company and the amount of its debts. (The same can be done for preferred stock.) If a business is $10 million in debt and its fair value is $30 million, at least in theory it has a 0.33 possibility of liquidation.
Before the bondholders suffer. The amount of this additional or precautionary value above the amount of debt can be approximated by using the average market price of the common stock over many years. Because the value is average, the margin of enterprise value over debt and the margin of enterprise income over expenses have similar results in most cases.
A lot can be said about the margin of safety in the case of (fixed value investments) such as bonds, but can they be applied to common stocks as well? The answer is yes, but with necessary changes.
When can you say, the time is good for a stock?
There are times when a stock can be considered good because it has a margin of safety as good as a bond. This happens when, for example, a company has only common stock and under recession conditions, it is traded below the price of bonds that it could issue with security against its assets and purchasing power.
This is the situation of industrial companies with a strong financial foundation at the prices of the floor of 1932 to 1933.
In such a situation, the investor can enjoy the margin of security of bonds, in addition to benefiting from all the chances of more income and price increase that are unique to stocks.
(The only thing that this investor does not have is the legal power to insist on dividend or non-dividend, which is a small weakness compared to his privileges.) Common stocks that are purchased under such conditions have an ideal opportunity, although rare. It is a combination of profit and safety.
Mention examples for better understanding
As a more recent example of these stock conditions, we present Swallow National Industries, whose total transaction value in 1972 was $43 million. With the company’s income of 16 million dollars or so, before paying taxes, this company could easily support the same amount of bonds.
In common stocks that are bought for investment under normal circumstances, the margin is mostly at the expected rate above the bond rate. Consider a typical company whose earnings are 9% of its price and its bond yield is 4%.
At this time, the stock buyer has an additional 5% average annual margin in his favor. A part of this amount is paid to him as a dividend, even if he spends it, it is considered part of the investment results.
The undistributed amount of profit is reinvested in his account. In many cases, the investor does not add such undivided profits to the purchasing power and value of the purchased share in a proper way.
(This is due to the stubborn nature of the market in valuing shares with dividends instead of undivided dividends.) But if we look at the picture in general, there is a logical close relationship between the growth of excess income of companies through the reinvestment of non-dividend profits and growth. There is a value of the shares of the companies.
The possibility of normal conditions in profitability
Over a ten-year period, the usual excess of the earning power of shares over bonds totals 50% of the money paid. This number includes many safety margins that will prevent or minimize the loss.
If such a margin of safety exists in each of the twenty or more stocks in the portfolio, the probability of favorable results under relatively normal conditions is greatly increased. This is because the investment policy on common stocks does not require special insight and foresight to be successful.
If purchases are made at the mid-market level over a period of several years, the prices paid contain a sufficient margin of safety. The risk for investors is to focus on buying shares at high market levels, and by buying shares off the stock exchange, the risk of buying their shares is higher than the average risk of losing the share’s earning power.
Margin of safety for the defensive investor
As can be seen, the main problem with investing in common stock under 1972 conditions lies in the fact that in one case the current earning power is much less than 9% of the price paid.
Let’s assume that a defensive investor, focusing on buying large companies with low ratios, can get bonds with 12 times the power of about 4% dividend and invest the remaining 4.33% for his own benefit in the same industry. Accordingly, the surplus of the share’s earning power compared to the bond rate over a ten-year period will still be too small to form a sufficient margin of safety.
Because of this, we think that there are legitimate risks in a well-diversified list of good common stocks.
These risks can be fully compensated by the possible profitability of the entire portfolio, and of course the investor has no choice but to face them. But on the other hand, it can only remove the greater risk of holding fixed income bonds that are slowly affected by inflation. However, it is useful for the investor to understand and accept the philosophy as far as he can that the old package is no longer available to him. Paying a lot of money for good common stock is not the main risk that threatens a common stock buyer.
The cause of investors’ losses
Our observations over many years have taught us that the major losses of investors come from buying low-quality bonds in good business conditions.
Buyers equate current good earnings with earnings power and assume that good performance means safety. In these years, bonds and preferred shares of low and inferior classes can be sold at nominal prices because these bonds have a slightly higher income yield or the seemingly attractive privilege of converting to shares.
Therefore, the ordinary shares of obscure companies can reach prices much higher than the value of their tangible assets, based on the fact that they have grown very well in two or three years. These stocks do not have enough margin of safety under any circumstances.
The coverage of interest expenses and dividends should be checked over the years, and during the period under review, it should preferably be a recession year and less than normal, such as in 1970 and 1971. The same issue is usually true for common stock income if they are to be used as indicators of earning power.
Profitability forecast is not always.
Therefore, it can be concluded that most investments in good conditions with the prices of spring and sunny days are prone to increasing price drops if the weather gets a little cloudy and many times even before it gets cloudy. An investor can never count on a hedge of profitability. (Although it can be done in some cases.) because it has created a margin of safety by diversifying the portfolio.