Three Magical Words

A few years ago, I first said, "I love you," to the woman who would become my wife. I did not realize it at the time, but those three words would eventually become three new ones: "Please marry me." Lucky for me, her response was, "Yes, I will!" And as often happens in such situations, a few months after our wedding, my wife spoke three more words to me: "Honey, I'm pregnant." Those are tremendously powerful life-changing events, each framed by three little words.

Now, well into her pregnancy, my wife clearly has the tougher end of the deal. As a dutiful dad-to-be, however, I've also been hard at work preparing for our new arrival. A significant chunk of my time has been spent buying everything we could possibly need, prepping the nursery, and assembling a bedroom full of Mattel's (NYSE: MAT  ) Fisher-Price brand of infant gear.

Since everything baby-related comes with some assembly required, much of my time has been spent poring over product manuals, trying to make sense of how the pieces fit together. The one thing I've noticed, based on seemingly hundreds of pages of bold-faced advisories and stern warning messages, is that safety is of paramount importance.

Investing's central concept
Not to make too big a jump, but safety is also crucial for the other current preoccupation in my life: value investors. Legendary value investor Benjamin Graham had his own three little words to describe it: "margin of safety." So important was that phrase, in fact, that he called it "the central concept of investment."

Simply put, the margin of safety recognizes that there is a difference between a company's current market price and the intrinsic value of the company. When market price is significantly below its intrinsic value, the difference represents a margin of safety. While it's not an absolute guarantee of investment profitability, most investors would rather buy a company for less than it's worth and wait for its price to catch up to its value than buy a company for more than it's worth and hope for its value to catch up to its price.

Oh, how I wish I had read Graham's words of wisdom before I purchased Merck (NYSE: MRK  ) . As I mentioned in "When Crystal Balls Break," when I bought Merck, I thought it was fairly priced at $41.23. I didn't think I'd found a value-priced company, but I did think that I had found a solid company at a decent price. I paid what I thought Merck was worth at the time and had no margin of safety to protect myself from any further bad news.

No pain relief for me
Of course, my purchase took place several months before Merck pulled Vioxx off the market or gave any public indication that its days were numbered. When Vioxx was withdrawn, 11% of Merck's revenues, and perhaps a similarly large percentage of its earnings, were removed. Without the power of Vioxx holding up the business, my intrinsic value estimate for the company dropped, significantly enough so that I no longer thought Merck was worth what I'd paid for it. Unfortunately, the market agreed with me and immediately adjusted Merck's price downward as well. In 20/20 hindsight, I realized that since I had no margin of safety in Merck, I practically assured myself that the first piece of significant bad news would spell an investment loss.

Fortunately for my portfolio, shortly after I bought Merck, my stock screen turned up "Book Value Bargains" subject Presidential Life (Nasdaq: PLFE  ) . With a market price of $14.05 per share and a book value of $16.38 per share, it offered a clear margin of safety. How large a margin? At the low end, I felt the company was worth at least its book value. At the high end, as I pointed out in "A Valuation Classic," I felt that a dividend discount model analysis could potentially justify a valuation as high as $17.88 per share. The differences between the stock price and my intrinsic value estimations gave me margins of safety of 14.2% and 21.4% relative to my estimates. That was enough to grab my attention, though it's a bit modest of a margin for the Fool's Philip Durell and his Inside Value newsletter.

Benjamin Graham's timeless wisdom still holds true today. His concept of investing only when a margin of safety exists forms the core principle around which the entire discipline of value investing revolves. It's amazing what three little words can do.

Fool contributor and expectant father Chuck Saletta owns shares of Mattel, Merck, and Presidential Life. The Motley Fool is investors writing for investors.


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