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[ December 1, 1999 ]

Margin of Safety

By Maynard Paton (TMFMayn)

When Warren Buffett describes a book as "by far the best book on investing ever written", any investor should sit up and take notice. The book he describes is, of course, The Intelligent Investor by Benjamin Graham. The book was reviewed in this Foolish Special.

The most important principle Graham describes is the "Margin of Safety". Graham calls it the "central concept of investment" and the "secret of sound investment".

When an investor purchases shares, they are bought with an expectation of the future prospects of that company in mind. General stock market moves aside, individual performance and future prospects of a company, by and large, drive the relevant share price up and down.

The trick for the investor, of course, is to be able to "see" into the future. It varies from company to company on the distance investors can see into the future. In one company, maybe investors can only see short term gloom. Contrast this to another company, where maybe investors can only see long term happiness.

The power of the investor's Crystal Ball though is at the heart of the Margin of Safety concept. In my introductory Fool's Eye View I wrote this paragraph.

"Just this year, there have been several high profile FTSE 100 companies with "surprise" profit warnings. If an army of Wise analysts, who pore over these long established companies day after day, don't foresee such occurrences, why should I take a chance on a profitless "jam tomorrow" business, where the future is even more uncertain?"

The examples I specifically had in mind were Glaxo Wellcome (LSE:GLXO), Rentokil Initial (LSE: RTO) and Marks & Spencer (LSE:MKS). All three are well known blue chips. Non of the three had suddenly changed the nature of its business. Yet all three "surprised" the market with various degrees of profit slowdown/decline. Genuine surprises these may be, but if in these long established and familiar industries, the unexpected can and does arrive, where does that leave companies that operate in the "industries of tomorrow"?

I'll leave that final question to those who own "tomorrow" companies. Back to the margin of safety principle.

If you are anything like me, then you won't have any special "insight" into one particular industry. That being the case, I readily admit that my powers of short term foresight will never be up to the same standard as, say, an analyst who spends each day, every day evaluating pharmaceutical companies. Nor will it be up to the same standard as a manager in the top echelons of a retailer. Both will have for more information, contacts and "expertise" on their chosen subject than I can ever attain.

Although I feel I can recognise a good business when I see it, I can only really go on its past performance. So, when I'm up against the aforementioned "professionals", predicting the short term future becomes a game I'd rather not play.

That's not to say there aren't some investors who appear to be able to see a clear and healthy future for certain businesses -- both short term and long term. These businesses are highlighted by, on a traditional basis, very high price to earnings (P/E) ratios -- that is, investors paying a "high" price today for the expected earnings of tomorrow and long into the future. However, investors without this specialised "lack of vision" aren't completely helpless. Graham makes this very important comment.

"…the function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future."

Going back, then, to highly rated companies. If the price paid has a great deal of expectation of future profits already included, then the margin of safety will only exist if the those future profits eventually exceed those profits originally expected, or are subsequently perceived to exceed those originally expected.

Graham hits the nail on the head with this type of investing.

"(The) buyer relies on an expected earning power that is greater than the average shown in the past… For such favoured issues the market has a tendency to set prices that will not be adequately protected by a conservative projection of future earnings… A special degree of foresight and judgement will be needed in order that wise individual selections may overcome the hazards inherent in the customary market level of such issues as a whole."

On the other hand, if you find a company that has a long, proven and consistent growth record and is available on a P/E multiple well below the market average, then the margin of safety in the prospective share price is more likely to exist. Obviously, the lower the price paid in terms of your conservative future projections (when compared to past growth), the better. Graham again: "When making an investment, the margin of safety is always dependent on the price paid."

Given that my own ability to predict long term growth is based entirely on the past and I have no particular deep insight into one industry sector, it seems sensible (but less exciting perhaps?) to consider companies on relatively low valuations. If the anticipated profit doesn't come through as expected, my downside is far more limited than that of a highly rated share. Always try to minimise the downside.

Here is Graham's Margin of Safety concept at work with an ex-Qualiport example. Hindsight investing at its best!.

Marks & Spencer (LSE: MKS) were purchased for the Qualiport in May 1998 at 553.5p. The three years up to then had seen Marks' earnings grow at an average of 7.5% a year, and its average P/E over the same period was 19.6.

Projecting a conservative 7.5% growth over the next five years, from the 27.2p earnings per share figure of 1998, gives expected EPS in 2003 of 39p. On a multiple of 19.6, this gives an expected price of 765p five years out. Of course, these assumptions are based at May 1998, before the retailer's well documented troubles.

So what purchase price would have given an adequate margin of safety on these rough projections? A price of around 380p would seem fair. That would give a 15% return over those five years, the Qualiport's expected return.

The larger the expected return, the larger the margin of safety. The larger the expected return, the less downside from the investment if the projections of growth are not met. The key is to use conservative projections of growth. As it turns out, Marks' growth expectations weren't met. The Qualiport subsequently sold Marks at 435p and 392p, which as it happens are above the 380p level indicated.

Of course, the Margin of Safety is a concept. There are no rules carved in stone as to how exactly you calculate a company's expected valuation. Graham quotes the concept as resting upon "simple and definite arithmetical reasoning from statistical data."

Finally, I'll leave the last words to Graham and some pertinent Qualiport investment thoughts. The second paragraph is particularly apt considering the portfolio's recent top-ups.

"However, the risk of paying too high a price for good-quality stocks -- while a real one -- is not the chief hazard confronting the average buyer of securities. Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favourable business conditions... It is, then, also, that common stocks of obscure companies can be floated at prices far above the tangible investment, on the strength of two or three years of excellent growth."

"Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if your judgement is sound, act on it -- even though others may hesitate or differ. (You are neither right nor wrong because your data and reasoning are right). Similarly, in the world of securities, courage becomes the supreme virtue after adequate knowledge and a tested judgement are at hand."

Any comments to the Qualiport board.

Qualiport Numbers
1/12/1999 Close

Company Change Bid DELL(US)-0.70 42.90 EMA -0.02 10.95 IIG -0.01 2.77 MSY +0.20 6.98 PIZ +0.03 7.65 RTO -0.03 2.36 ULVR +0.03 4.60 LLOY +0.17 8.18
Qualiport Stocks Last Rec'd Total # Company Buy Current Change 22/04/99 542 Misys 5.57 6.98 25.2% 29/09/99 356 Lloyds TSB 7.56 8.18 8.3% 17/04/98 301 Emap 10.20 10.95 7.3% 27/10/98 1133 Indep Ins 2.60 2.77 6.5% 04/11/98 245 Pizza Exp 7.93 7.65 (3.5%) 27/01/99 74 Dell (US) 44.63 42.90 (3.9%) 19/12/97 783 Rentokil 2.55 2.36 (7.5%) 17/07/98 266 Unilever 7.53 4.60 (38.9%) Last Rec'd Total # Company In At Value Change 22/04/99 542 Misys 3065.85 3783.16 717.32 29/09/99 356 Lloyds TSB 2723.20 2912.08 188.88 17/04/98 301 Emap 3139.85 3295.95 156.11 27/10/98 1133 Indep Ins 2990.63 3138.41 147.86 27/01/99 74 Dell (US) 2007.42 1924.00 (83.42) 04/11/98 245 Pizza Exp 1966.34 1874.25 (92.09) 19/12/97 783 Rentokil 2046.53 1847.88 (198.65) 17/07/98 266 Unilever 2052.00 1223.60 (828.40) Cash: £ 28.46 Current Total : £20,027.79 Total Invested: £20,184.62 Profit/(Loss) : (£ 156.83) Value Per Share Day Month Year Qualiport 0.56% 0.56% -5.17% FTSE 100 0.74% 0.74% 12.98% FTSE All Share 0.60% 0.60% 16.14%