Let's take a look at telecom manufacturer Nokia (NYSE: NOK) to talk about Benjamin Graham's margin of safety concept.
Finland-based Nokia is the world's largest maker of cellular telephones. It's a giant. However, these last couple of quarters have been tough if you spent lots of time watching Nokia's stock price. Since December its shares have drifted down from the rooftop like Finnish snow, settling around $17 -- a cool 70% drop.
In June, Jorma Ollila, chief executive and full-time Nokia promoter, announced that, indeed, the slowing U.S. economy will impact second-quarter results. The shares have slid, and slid, and slid. Nokia reports earnings July 19.
Now, Ollila talks too much, but other than that he hasn't done anything wrong. The company will continue to wow consumers with its curvy cell phone designs, grow faster than the market, beat up on U.S. technology icon Motorola (NYSE: MOT), and give Ericsson (Nasdaq: ERICY) a run for its money in the cellular infrastructure business.
We aren't watching Nokia's stock price, fluttering downward as it is, in agony. We aren't relying on the market to tell us how much the company is worth. Neither am I going to try to tell you how much I think the company is worth.
But flash back to a bright day in October when I wrote a story called Nokia's Price Is Right. (The title overstates the tenor of the story, but I've nowhere to hide since I wrote it.) At the time the shares traded around $36. I argued that the shares were expensive, that the projections were strongly bullish, yet the stock traded at a reasonable price based on Nokia's sustainable growth rate, which I calculated using the company's historical return on equity (ROE).
Indeed, things looked rosy from this point of view. Nokia had improved each component of its ROE over the last five years -- profit margins, asset turnover, and leverage. At the time, I estimated Nokia would have to grow its free cash flow 20% annually for 10 years to justify its price.
It's early yet. It may happen. The current price doesn't make the story I wrote in October wrong today. It does, however, provide an example of what Graham was talking about when he wrote these lines in The Intelligent Investor: "Here the function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future."
Graham was a cautious fellow. He insisted upon a margin of safety in all his investments. He would not have paid the prices we did to own shares of stalwart Coca-Cola (NYSE: KO) and flashy Cisco (Nasdaq: CSCO), both bellwethers. It's important readers understand we don't look for a margin of safety in this portfolio. Rather, we try to avoid paying too high a price for a business we know is excellent. Is this mincing words? If it seems so, then Nokia's slide should put the matter in focus.
At $36 a share, we paid up for Nokia. Investing in a company that must grow cash flow at a rate remotely close to 20% annually for 10 years isn't within striking distance of a margin of safety. It's not impossible for a superior company, but it is a dicey bet even for a champ.
In the Rule Maker, the approach we have generally taken is that we will sacrifice margin of safety rather than miss an opportunity to own a great business. In my opinion, this is a mistake. It's hasty thinking. We don't have to sacrifice margin of safety.
To Benjamin Graham's great words then, I add a few small words of my own. The margin of safety concept applies to the Rule Maker strategy as much as any other investing tack. We just have to dig deeper, and let a few of the flashier horsemen pass by.
Have a great day.
Richard McCaffery doesn't own shares of any company in this report. Furthermore, this has been the crummiest bear market he has ever seen. The Motley Fool is investors writing for investors.