Undervalued Weekly
The Undervalued Reports Company’s weekly newsletter
Towson, MD
December 13, 2003
http://www.dynamicinvestors.net
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The snow has finally melted away here in the greater Baltimore region, just in time for more snow! I used to like snow when I was a kid, because it usually meant time off from school. I never had to worry about cleaning the car off to get to work, and shoveling snow was a business venture, not a chore. It was so much fun to play in the snow. I miss those days. But the business of business stops for nothing, so as adults (sort of) it’s off to work in the snow.
First, some announcements to take care of:
Week 1 of the Undervalued Weekly subscription promotion is almost over, with one person way ahead. The next week of the contest starts tomorrow, and everyone starts with a clean slate. There’s still time to get in, but don’t wait. Remember, this week’s contestants don’t get to carry their totals over to next week, so if you haven’t joined the contest yet, it doesn’t matter. If you want to get involved, click here.
I’ve made some updates to the Dynamic Investors website, and if you haven’t been there in a while, you should really check it out. The biggest change has been the addition of my daily update. I’ve done away with the old blog, and replaced it with a daily commentary on the markets and the economy.
Since I’m now doing commentary every day, I no longer plan to have the market update in the Undervalued Weekly. I’ll still make some notes on the week, but nothing like I’ve been doing. If you want to hear me flap my gums, you can do so every day with the daily update. I welcome your feedback on this change, so e-mail me at chrismallon@dynamicinvestors.net.
Enjoy the margin of safety article conclusion. It’s an important concept, and one you should take very seriously.
Enjoy the weekend, and don’t forget to sign up for the subscription promotion.
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Book Recommendation
This week’s book recommendation is Adventure Capitalist, by Jim Rogers. As George Soros’ partner in the Quantum Fund during the 1970’s, Rogers earned made a fortune and retired a millionaire at age 37. Since that time, he’s kept busy by traveling around the world, first on a motorcycle, then in a souped-up Mercedes. Adventure Capitalist chronicles Jim’s second trip around the world, on which he visited 116 countries and covered more than 245,000 kilometers.
But this book is more than just a story about an around the world trip. Rogers, being a life-long investor, gives his readers information on emerging trends and opportunities around the world, from the ground level. This book is a fascinating read, full of useful information, with a love story and tragedy to boot. This one will go down as one of my all-time favorites.
Get the book here:
For more must-have books, check out the Dynamic Investors Required Reading.
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Margin of Safety Part II
Last week we began our discussion on margin of safety. Ben Graham defined the margin of safety’s purpose as “that of rendering unnecessary an accurate estimate of the future.” I defined the margin of safety, as it relates to common stocks, as the difference between the conservatively estimated intrinsic value of a stock and the price for which it sells.
The intrinsic value of a stock can be calculated in a number of ways, and for surety purposes you should come up with more than one estimate. Normally, intrinsic value is based on cash flows or earnings, but you can also use balance sheet ratios. Intrinsic value must be estimated conservatively. There’s nothing worse than buying a mediocre company during strong business conditions, simply because your intrinsic value estimate was too high.
The margin of safety concept is applicable not only to the ownership of a single stock, but also to a diverse portfolio. The concept of diversification is a natural extension of the margin of safety. Investors diversify in their portfolio to spread risk, and increase the odds of making a profit. As you add stocks to your portfolio, the aggregate odds of making a profit increase, provided that you purchase each stock with a margin of safety. A single stock can perform poorly, even if you purchased it with a margin of safety. Margin of safety doesn’t guarantee you’ll make a profit on the stock, only that the odds are more in your favor.
Let’s take an example from Graham:
“Diversification is an established tenet of conservative investment. By accepting it so universally, investors are really demonstrating their acceptance of the margin-of-safety principle, to which diversification is the companion. This point may be made more colorful by a reference to the arithmetic of roulette. If a man bets $1 on a single number he is paid $35 profit when he wins – but the chances are 37 to 1 that he will lose. He has a “negative margin of safety.” In his case diversification is foolish. The more numbers he bets on the smaller his chance of ending with a profit. If he regularly bets $1 on every number (including 0 and 00), he is certain to lose $2 on each turn of the wheel. But suppose the winner received $39 profit instead of $31. Then he would have a small but important margin of safety. Therefore, the more numbers he wagers on, the better his chance of gain. And he could be certain of winning $2 on every spin by simply betting $1 each on all the numbers. (Incidentally, the two examples given actually describe the respective positions of the player and proprietor of a wheel with 0 and 00.)[i]
Diversification is not a panacea, however. Each stock must be evaluated on its merits, and purchased with a margin of safety. A diverse portfolio of stocks purchased with no margin of safety defeats the purpose entirely. You will not increase your odds of making a profit when you buy overpriced stocks. Just ask the late-nineties’ tech investors.
Understand also that diversification for diversification’s sake is not going to produce outsize profits. Just as the law of averages says that diversifying will lower your risk, it will also lower your potential for profit. Statistically, as you add stocks to your portfolio, the quality of the next stock, on average, will be less than what you currently own, provided you purchase each stock with a wide margin of safety.
Obviously smart investors beat the average, and try to add better stocks to their portfolios. Regardless, the law of diminishing returns tells us that once you’ve reached a certain number of stocks in your portfolio, adding more will result in less return for the additional risk. This is part of the reason mutual funds have such a difficult time continuously outperforming. If you look at the holdings for any common fund, you’ll find literally hundreds of holdings. This fact alone pushes returns to the mean, or the market return.
Generally, I recommend that you have no more companies in your portfolio than you can honestly keep track of. Think of your portfolio as a business investment, because that’s really what it is. The best investments are those made in a business-like manner, and successful businesses don’t take on more than they can handle. You should be comfortable in what you know, and make investments within your sphere of knowledge.
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You have to do the math. If your reasoning is sound, and you’ve found an investment that offers a margin of safety based on conservative estimates, then ignore the crowd and trust your analysis. Benjamin Graham put it best when he said, “You are neither right nor wrong because the crowd disagrees with you. You are right because you data and reasoning are right.”[ii] When you’re tempted to ignore your own reasoning in favor of the popular perception, remember that statement.
Altria is a good example. Altria (symbol: MO) is the name of the old Philip Morris Companies. In April, 2003 Altria stock was trading around $29 per share. The P/E ratio was under 6, the dividend yield was close to 9%, and the stock was at a three year low. A number of lawsuits were in process against the company, and an Illinois judge had issued a $10 billion judgment against the company. The kicker to the ruling: The company had to put up a $10 billion bond to guarantee the chance to appeal.
The company was derided in the media, and nobody would touch the stock. But, if you had done the research into past lawsuits against Philip Morris USA, you would have felt comfortable that the $10 billion judgment wouldn’t stand on appeal (which it didn’t), and the bond requirement would be reduced (which it was). The company was severely oversold at $29 a share, based on the dividend yield alone. Careful analysis showed that the company’s free cash could drop 50% before they’d have to cut the dividend. Yet you couldn’t find anyone to say publicly that the stock was worth buying.
If you had ignored the popular opinion and bought Altria at $29 you’d be up 79%, and collecting a 9.4% dividend. The math was screaming buy, and those who did are very happy. Coincidentally, now that the stock is up almost 80%, the media and brokerages are jumping on board, calling the stock undervalued and upgrading it. My question is: If it’s undervalued at $52, what was it at $29? Was there not a tremendous margin of safety in the stock at $29? I would venture to say there was.
All the analysis you do on an investment leads finally to the margin of safety. It’s the investor’s most important tool, because it forces you to detach yourself from emotional decision making and justify your investment purchases. If you’re buying stocks based on outside judgment, without doing your own analysis, you may wake up one day with less money than you started. You don’t want that to happen, and if you focus on investments that offer a large margin of safety, the odds are good that you’ll have more money than you started with.
Finding stocks that provide a margin of safety requires hard work, and the guts to move against the crowd. If you’re looking for average returns in line with the market, you don’t need to worry about the margin of safety. You just buy S&P 500 Index funds, and go back to sleep. And I’m in no way deriding that philosophy, as my own retirement account is set up that way. I hold only cash and the S&P 500 Index in my 401k. But if you want market beating returns, you must use the margin of safety concept to invest in common stocks.
Ben Graham put it this way, “To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks.”[iii]
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Quotes of the Week
"There's no place where success comes before work, except in the dictionary."
-Donal M. Kimball
"To be a leader, you must stand for something, or you will fall for anything"
-Anthony Pagano
Until next week my friends, happy investing. Don’t forget to forward this newsletter to a friend.
Sincerely,
Christopher M. Mallon
Have you checked out the Dynamic Investors Marketplace?
How about the Required Reading?
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Attention authors!
The Undervalued Weekly is always looking for quality original content. If you’d like to write an article for publication in the Undervalued Weekly, send a copy of your article to undervalued@dynamicinvestors.net. Include a one-paragraph abstract of your article, and a working e-mail address. I will contact you if your article is approved. I reserve the right to correct any grammatical mistakes.
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