Margin of Safety

In value investing, it is imperative that one considers the state of the industry invested in, the balance sheet of the company, and earnings quality.  These are basic concerns for any investor, and all of my failures in investing can be be linked to neglect of one of these three items.

Ben Graham used the phrase “margin of safety.”  Actuaries, even less poetic, use “provision for adverse deviation.”  In either case, the idea is investing in such a way that you won’t get badly hurt if you are wrong.  It handles risk at the security selection level — choose your companies carefully; make sure they are survivors.

Does the industry have pricing power?  Is it under pressure from rising costs?  (Credit losses are a cost for financials.)  Pricing power, and lack thereof, should be considered in valuation decisions.  Are things so bad that companies are going bankrupt?  Perhaps it is time to buy the strongest one in that industry, because it often takes defaults to make pricing power turn.  Fewer competitors means profit margins can rise.

Does the company have a lot of debt?  Is the tangible net worth small relative to the liabilities?  Be careful, because a small negative change in the economics of the business could kick the company over the edge.

Do the earnings come from cash earnings, or do accruals dominate the earnings?  Cash earnings are always higher quality than accrual earnings.  This is one reason why financials almost always trade at a discount, becausethey are a bag of accruals.  Also, with financials, the quality of the accrual entries affects valuations.  Asset managers will have higher valuations than long-tail P&C insurers.  Who knows whether the reserves are right or not?

All that said, it was with sad amusement when I heard on the radio this afternoon that Legg Mason had become the largest shareholder of Freddie Mac.  Is Bill Miller (or Private Capital) doubling down?  He will look like a genius or a fool after this, depending on the outcome.  I think it is foolish, and an willing to say that he doesn’t understand the credit risk in the current environment, and should get advice from someone who gets the current credit crisis better, like me, or Eric Hovde.

After all, at the present time, even the rating agencies are downgrading everything at Fannie and Freddie except the senior debt ratings.

Value investors often invest in financial stocks.  That is their undoing in the present market, as earnings and net worth get eaten by credit losses.  But to any value investor that does industry analysis, this was avoidable, because the risk of credit losses to the banks grew as the banks were willing to lend on terms that were loose.

As a value investor, I have been able to avoid the current crisis.  I avoided credit-sensitive financials, and have bought cheap names among industrial stocks.  But that was yesterday, what of tomorrow?  I don’t think the credit crisis is done, and so I urge a conservative posture at present.