Chas Craig, BridgeTower Media Newswires
"Confronted with a challenge to distill the secret of sound investment into three words, we venture to motto, MARGIN OF SAFETY."
Benjamin Graham
Today we avoid spilling more ink regarding COVID-19, which represents a serious, but likely transitory, disruption to business activity and instead focus on a topic of significant long-term importance, margin of safety.
Unfortunately, there is no specific prescription for the proper margin of safety, so the ultimate margin of safety applied to a given situation (herein we discuss common stocks) is dependent upon qualitative factors such as the risk tolerance of the investor in question, the level of confidence the investor has in his estimation of per share value and the quality of the business being analyzed. Below we discuss how we approach this problem.
In analyzing businesses in which we may invest, we think of companies as generally belonging to one of three categories: (1) Super-Prime, (2) High-Quality and (3) Mediocre. It is important to point out that these are points on a spectrum, not absolutes. Companies of the Super-Prime sort are large enterprises exhibiting characteristics including extraordinary management, high barriers to entry and pricing power. An example of a High-Quality business might be one that is well run and conservatively financed but operates in a commoditized business where there is no real pricing power. Finally, a company exhibiting stagnant earning power over a long period would most likely be categorized as Mediocre.
While reasonable and informed people can come to different figures, we are typically willing to pay 75 cents, 66 cents and 50 cents per $1 of estimated intrinsic business value in the case of Super-Prime, High-Quality and Mediocre companies respectively. These margin of safety figures, or even more draconian ones, may only result a few qualifying individual stocks under normal market conditions. The inclusion of mutual or exchange-traded funds in a portfolio could help achieve the proper level of diversification.
The preceding paragraph speaks to our discipline regarding the initial decision to buy. Once holders of a company, we monitor its fundamental progress and update our estimate of intrinsic business value accordingly. Regarding our sell discipline, we become willing to part ways with a holding upon the margin of safety being meaningfully (everyone will have their own opinion about what meaningful means) reduced or eliminated. If all goes as planned, the margin of safety will be mostly reduced by price gains. However, margins of safety can also be reduced by deterioration in intrinsic business value, and in those hopefully seldom instances, selling at a loss may be rational.
There may be happy times when price gains occur quickly. We are willing to sell at such times even if our holding period is extraordinarily short. This may at times give the impression that we are short-term "traders" rather than long-term investors. We disagree, as our estimate of intrinsic business value is based on an assessment of the company through a long-term lens. While this position may not be conventional, we do believe it is rational.
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Chas Craig is president of Meliora Capital in Tulsa (www.mel capital.com).
Published: Mon, Mar 16, 2020
