Though my investing tends to be fairly conservative, I occasionally make some rather questionable decisions in other parts of my life. Case in point, I recently went out for a late-night run along a two-lane highway while traveling in southern Delaware.
What I quickly found out about my route was that while there was a generous amount of room in a bike path along the side of the road, there were no streetlights whatsoever, so the only light along the way was the rush of oncoming traffic. But I decided to run on anyway.
While running, I had to make the decision of where specifically in the running path I should tread. There were the obvious dangers of running too close to the road, but the other edge of the path was a none-too-inviting combination of high grass and brackish bay water. So what did I choose? Maybe not all that surprisingly, I decided to run very close to the bay-water edge and stay far away from the edge where cars were flying by.
Finding a margin of safety
For Foolish investors, the term "margin of safety" could be one of the -- if not the -- most important investing phrases. On my run, I chose to keep as much of a cushion as possible between me and the cars so that a slight misstep by me or a quick swerve by a driver wouldn't turn me into a hood ornament. For investors who invest with margin of safety in mind, it means buying stocks that provide a nice cushion between their portfolio and disastrous losses.
How exactly do you do that? It all boils down to price and value. If you buy a stock for exactly the amount that you think it's worth, then you have no protection if something happens to change the value of the company or it turns out that your calculations were off. Essentially, it's running right on the edge of the road near the traffic -- you'll be perfectly fine assuming you do everything right and the drivers do everything right.
If, on the other hand, you buy a stock for less than you believe it's actually worth, you've given yourself some built-in protection. If your model miscalculated or the company stumbles, you may still end up with very acceptable returns. And if everything goes according to your initial estimates, then you'll snag some extra returns.
The downside of being picky
Of course if I were to extend the metaphor a little further, there is risk in insisting on investing with a margin of safety. My choice to run near the bay meant that there was the chance that a misstep could have sent me stumbling into the stinky water. But for me, the prospect of avoiding the cars flying by was much more of a priority than guaranteeing that I stayed out of the bay.
For investors who require a margin of safety for their investments, there is the very real risk of underperforming the market or looking silly for periods of time. When Mr. Market gets really excited, the number of investments that include a margin of safety in their price can dwindle quickly and cautious investors can be left sitting on their hands while the herd around them cheers Internet stocks, Floridian real estate, or social networking websites.
This scenario can be uncomfortable and a bit stinky -- like falling in the bay -- but is generally highly preferable to resigning to a riskier approach. As Warren Buffett has said, "You only find out who's swimming naked when the tide goes out." Eventually, the tide always goes out and it's the investors who didn't insist on a margin of safety that are left hanging out in their birthday suits.
Right here, right now
All of this is great in theory, but the big question is whether there are stocks available right now that include a margin of safety. The full answer to that question for any individual stock takes more room to work out than we have here. However, as a start, one way to find stocks that are promising is to look for those companies that are growing faster than average and yet sell at a price that is less than average.
As a starting point, over the past 10 years, the current S&P 500 companies have grown an average of 8.7% per year. Over the longer term, total S&P 500 earnings have grown an average of 3.8% per year. As for price, the average S&P 500 company currently has a trailing price-to-earnings ratio of 21 and a forward P/E of 16. Historically, trailing P/Es have been closer to 15.
With those averages in mind, the following stocks look like they're priced with a healthy margin of safety.
Trailing 5-Year Growth Rate
Expected 5-Year Growth Rate
Source: Capital IQ, a Standard & Poor's company.
In each case above, the company has grown faster than average, is expected to grow faster than average, and yet trades at both trailing and forward multiples that are below average. Investors need to dig into each of these companies to figure out whether the growth expectations are actually attainable, but it appears that there is a very healthy margin of safety built into the valuation of each.
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