What's your Margin of Safety

[netnet]

This article got me thinking:http://wallstreetrumble.tumblr.com/post/116235902584/margin-of-safety-the-lost-art.

 

 

This analyst has an equity MoS of 15%.  Now I found that really shocking.  That is no margin of safety; that is really the  error bounds on your calculations of value.(Which he sort of admits!)

 

Somehow a MoS of 15% doesn't begin to make me want to invest. (One could of course argue that there is no MoS in an index, which would stop you from using an index fund, but that is apples and oranges comparison and the retort is that indices beat 80% of active managers anyway.)

 

Unless it is a jockey stock, great jockey and a decent horse, my MoS is at least 30-40%.

 

 

[rpadebet]

Like everything else, the answer here is "it depends"...

 

If the earnings can grow at 10% and I am targeting a 15% return over say 5 years, I need that 5% difference per year to come from multiple expansion+dividends. Dividends are pretty static in most cases over this time frame, so my margin of safety is determined by the amount of multiple expansion required and the likelihood of that happening. Say dividends are 2%, then I would be happy with a 15% discount to current value only if the business is a "sure thing" and things are 100% likely to normalize in my time frame.

 

As my estimate of that likelihood varies, I vary the discount I need higher.

[DavidVY]

For inflation adjusted equity-bonds (mature markets with stable respected management)- Nestle, Diageo, Hersheys and McCormick I would be fine with fair-value (PE of 20-25) and paying out 3-4% dividends. I get equity up-side with some cashflow. These business self-adjust to inflation. <--- This is just a bond substitute.

 

With everybody else I want at least a 50%- 100% intelligent speculation upside.

[orthopa]

For inflation adjusted equity-bonds (mature markets with stable respected management)- Nestle, Diageo, Hersheys and McCormick I would be fine with fair-value (PE of 20-25) and paying out 3-4% dividends. I get equity up-side with some cashflow. These business self-adjust to inflation. <--- This is just a bond substitute.

 

With everybody else I want at least a 50%- 100% intelligent speculation upside.

 

Do you mean self adjust to inflation via multiple expansion or contraction?

[DavidVY]

Well I would said multiple expansion is a factor in valuation. PE Multiple will expand to reflect equity-premium to risk-free rate.

 

BUT what I meant to say is that all these products will self-adjust to inflation. If Nestle's COG goes up, the retail price will go up (or package size will shrink). People don't really count the 5-10% increase in ice-cream prices. They still buy Drumsticks. I def. don't care much about price increase. It was 2 dollars for 4 pieces 3 years ago. Now its 2.50-3 dollars for 4 pieces.

 

Voila Inflation Adjustment!

[lathinker]

At the time of purchase, I will normally target a 15% return per year and at least 3 years time for Mr. Market to fairly value the security. This brings me to require an MOS of 50% or more. I am fine to hold a bit longer if needed which cuts the IRR. 15% was mentioned by Buffett as his hurdle rate.

 

Now, I think it is a fair discussion whether or when to amend your MOS requirement, in particular in times of zero interest rates. At the same time, I find it quite dangerous water down your return requirement as nobody knows, what interest rates or inflation will be in the future. Therefore, I try to resist purchasing "high quality companies" at lower margins unless I understand their moats very clearly and am confident for them to persist.

 

[racemize]

I use a sliding scale--the better the business, the less MOS required, using a hurdle rate of 10% per annum expected return.  So BRK at book value or maybe up to 1.2 or 1.3 will meet it, at the higher end.  But if it is something that is a terrible business or one I'm less interesting in owning for a very long time, I want more like a 50% MOS.

[innerscorecard]

I use a sliding scale--the better the business, the less MOS required, using a hurdle rate of 10% per annum expected return.  So BRK at book value or maybe up to 1.2 or 1.3 will meet it, at the higher end.  But if it is something that is a terrible business or one I'm less interesting in owning for a very long time, I want more like a 50% MOS.

 

Isn't that double counting, both for the good businesses and the bad businesses, since that q

[innerscorecard]

I use a sliding scale--the better the business, the less MOS required, using a hurdle rate of 10% per annum expected return.  So BRK at book value or maybe up to 1.2 or 1.3 will meet it, at the higher end.  But if it is something that is a terrible business or one I'm less interesting in owning for a very long time, I want more like a 50% MOS.

 

Isn't that double counting, both for the good businesses and the bad businesses, since that quality should already be incorporated into your rough valuation of the company?

[Travis Wiedower]

I really took to Mohnish Pabrai's thoughts of only investing in companies that can at least double or triple over the next 3-5 years. If I can't realistically envision a stock at least doubling over a couple year time frame it's a pass. Having this high of a hurdle forces me to be extremely picky which I love.

[racemize]

I use a sliding scale--the better the business, the less MOS required, using a hurdle rate of 10% per annum expected return.  So BRK at book value or maybe up to 1.2 or 1.3 will meet it, at the higher end.  But if it is something that is a terrible business or one I'm less interesting in owning for a very long time, I want more like a 50% MOS.

 

Isn't that double counting, both for the good businesses and the bad businesses, since that quality should already be incorporated into your rough valuation of the company?

 

I see what you mean.  I think I'm usually pretty cheap on valuation anyway.

 

Perhaps I'll say it this way--I try to determine the predictability of the returns.  If the returns seem very predictable and match my hurdle, then a lesser MOS can be used (e.g., BRK at book value).  If the returns seem less predictable and match my hurdle, then I would want a larger MOS (thus, providing more return if it doesn't work out, and less downside as well) (e.g., EZPW at current prices). 

 

I think the same thing could be achieved by valuation, as you say, however.

[Guest Schwab711]

Well I would said multiple expansion is a factor in valuation. PE Multiple will expand to reflect equity-premium to risk-free rate.

 

BUT what I meant to say is that all these products will self-adjust to inflation. If Nestle's COG goes up, the retail price will go up (or package size will shrink). People don't really count the 5-10% increase in ice-cream prices. They still buy Drumsticks. I def. don't care much about price increase. It was 2 dollars for 4 pieces 3 years ago. Now its 2.50-3 dollars for 4 pieces.

 

Voila Inflation Adjustment!

 

I feel like I just wrote about this but be careful between brands you've heard of and pricing power. Campbell's Soup has zero pricing power  but its brand is consistently valued in the billions. That brand is only valuable because they can find shelf space easier but it doesn't increase gross margins. The company with the most pricing power I've seen doesn't even need a "brand" (TDG). Look for companies that have an annual press release talking about price raises or just assume they don't have pricing power.

[dabuff]

Pabrai once said that when he gets stock tips, he wants to hear about stocks worth 20 and selling at 10 or less, not 11, not 16, but 10 at the max.

 

 

[UNF2007]

What I do is try to get to a reasonable earnings power value, based off adjusted operating earnings and then capitalize those earnings with a discount rate of anywhere between 10-12% depending on how strong I think the franchise is (if there is one), which is purely a qualitative judgement. I then want at least a 33% discount to that fair earnings value to invest. I don't build growth in as a MoS at all as I am not really that great at identifying those companies where growth is dependable and profitable (I wish I was). As it moves up in price and the MoS shrinks I start asking myself the question, how sure are you this is worth x?, and is it worth it to wait for it to get to x given what has happened since it was purchased, is it better to sell and capture what ever percent of the mispricing has corrected? Obviously the closer it gets, the smaller the MoS gets, and the more anxious I get about selling. I'm usually selling around 90% of intrinsic value and up. Although I have almost always sold to soon, it is a problem with my process, I'm working to get more comfortable holding up to and past 100% of IV on high conviction ideas.