Why Valuation Matters

On the day before Christmas, the Inflation-Protected Income Growth Portfolio unwrapped an early gift from Santa Claus, delivered by way of the stock market -- a bargain price on Hasbro (NASDAQ: HAS  ) stock. Hasbro looked to be worth buying, but only at a price below $37 a share.

After the Fool's disclosure policy allowed, the iPIG portfolio did pick up shares of Hasbro at $35.20 a stub (plus commission) -- below that $37 price point. In the month since then, Hasbro's stock had been on a tear -- reaching as high as $39.10. With around an 11% upward move in less than a month, it was starting to look like Hasbro would be an early and quick win for the portfolio.

And then, reality struck
Things looked great until last Friday, when Hasbro released a warning about missing its revenue targets for the all-important December quarter. On that news, Hasbro's stock plummeted $1.14, nearly 3%, to finish the day at $37.31. That'd be bad news for someone who had just bought the day before, but for those of us who set guidelines on how much we're willing to pay, things turned out just fine.

Even after that drop, after all, Hasbro's stock still wound up above the buy-below price that the iPIG portfolio was willing to pay, and even further above what the portfolio actually did pay for its stake. It's another case where following Benjamin Graham's timeless lessons on the benefits of buying with a margin of safety paid off.

You see, while the portfolio's valuation pegged Hasbro's intrinsic value at around $6.2 billion, I wasn't willing to pay a price that valued the company at more than about $4.8 billion. As called out in the original selection, there were real risks facing the company. It only took a month before some of those risks came to fruition. I still believe the company is worth owning, and the iPIG portfolio isn't planning to sell on the news, but the drop does serve as an important reminder of why valuation and risk matter.

That's why we're still waiting
Contrast the success we had paying a low price for Hasbro with the potential "one that got away" scenario from pipeline giant and fellow portfolio selection Kinder Morgan (NYSE: KMI  ) . I've owned its sister company Kinder Morgan Management for years and trust that its management has a solid handle on the risks of running the business. As a result, I was willing to accept a lower margin of safety in the iPIG portfolio on Kinder Morgan than I was on Hasbro.

A lower margin of safety was acceptable, but not a negative margin of safety. So when Kinder Morgan quickly leaped past both the portfolio's $36 buy-below price and the $36.16 calculated for intrinsic value, it shifted from "buy" to "wait." Kinder Morgan still looks like a company worth owning for the long haul, and I still own that sister stock, but with no margin of safety in its price, the potential reward didn't seem justified by the risks.

Ultimately, one of the following will happen with Kinder Morgan and the iPIG portfolio:

  • The stock will fall to a price where it seems to be worth buying for the portfolio.
  • The company's intrinsic value will increase to where it looks to be worth buying at its then current price.
  • The iPIG portfolio will find a different stock that looks like a better fit from a valuation perspective and use that to fill the spot currently reserved for Kinder Morgan.

But as Hasbro's recent revelation showed, ignoring valuation to buy Kinder Morgan's stock exposes an investor to even more of the risks that any company faces.

What comes next?
If you'd like to follow along with this real-money portfolio as it balances across risks, including valuation-related risks, in an attempt to build an income stream that grows faster than inflation, you can. Simply watch my article feed for details of the next selection, coming soon. As long as the valuation still holds, I'll buy each selection with real money for the iPIG portfolio once the Fool's disclosure policy permits.

More expert advice from the Motley Fool
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