With respect to stocks, Merriam-Webster defines risk as "the chance that an investment (as a stock or commodity) will lose value." So how can we mitigate this risk? Many investors simply choose to avoid riskier sectors, like tech. But there's a better way. Mitigate the chance for loss by buying stocks with a margin of safety. On that note, here are two low-risk stock picks: Apple (NASDAQ: AAPL ) and Baidu (NASDAQ: BIDU ) .
"In business, I look for economic castles protected by unbreachable moats," Warren Buffett has famously said.
Determining a company's margin of safety is impossible if the company doesn't possess some sort of economic moat. An economic moat is what protects a company's future cash flows from competitors. If a company doesn't have any sort of competitive advantage, it would be impossible to estimate future cash flows, a key ingredient to any stock valuation. And a margin of safety, of course, cannot be determined without valuing a stock to determine your best estimate of the company's value.
Both Apple and Baidu are definite leaders in their respective markets, giving them considerable scale in comparison to their competitors. Apple, according to Canaccord Genuity, boasts 57% of worldwide smartphone profits despite just 8% worldwide smartphone market share, and Baidu has China's online search market wrapped up, with about 73% market share.
Margin of safety
Estimating a company's margin of safety begins with a valuation. I'll use one of the most common methods: a discounted cash flow valuation.
Analysts, on average, expect EPS growth of 20% per annum for both Apple and Baidu over the next five years. But let's modify these estimates with some conservatism.
Samsung is undoubtedly quickly gaining on Apple in terms of the industry's share of profits. On that note, I'll predict 8% growth in EPS in year one for Apple, and decelerate that growth rate by 10% each year for the next 10 years. By year 10, growth expectations would be about in line with inflation, at 3.1%. In years beyond 10, we'll estimate 3% growth per annum.
Baidu is facing some tough competition from browser-maker Qihoo 360. But the search business is far less wishy-washy than Apple's business model, which is highly dependent on blockbuster products. So, I'll stay closer to analysts' estimates -- going with a 15% estimate in year one, estimating this growth rate to decelerate by 5% each year. By year 10, growth expectations would equal 9.5% -- still fairly high, as the company rides the wave of a growing Chinese economy that will increasingly increase their spending in digital advertising.
Tech stocks can be cheap, too
The results? Apple and Baidu trade at 34% and 23% discounts to fair value, respectively. A margin of safety of just 23% is borderline, but a whopping 34% discount to fair value for the top company on Fortune's 2013 World's Most Admired Companies list is a steal.
So, add these two stock picks to your watchlist, and consider adding Apple to your portfolio. Both stocks remain top picks among my CAPScalls.