Central to the art of value investing is the concept of a company's intrinsic value. It's a number that represents an investor's understanding of the true worth of a firm under consideration.
After determining that magical number, value investors will purchase shares only if the market price for the company is significantly below that intrinsic value. That discount off the company's fair price is called the margin of safety. And the larger that margin at the time of purchase, the better the odds of superior risk-adjusted returns for investors.
There are two key reasons why the margin of safety gives investors a better-than-decent shot at coming out ahead. By taking advantage of both, Motley Fool Inside Value advisor Philip Durell has put together a series of recommendations that together have trounced the S&P 500 during the short life of the service. Of course, the race is just beginning, and there are no guarantees in the stock market. But there is significant historical data to suggest that Philip's strategies just might keep their lead.
The first reason is that the margin of safety provides a measure of downward protection against corporate stumbles. Unless you have a crystal ball that works better than mine does, you will invest in at least one company whose business fails to perform to your expectations.
Crash protection
When I bought Merck (NYSE:MRK) in late 2003, my total cost came to $41.24 a share, about in line with my estimate for the value of the firm. That was, of course, before Merck shocked the world by pulling its blockbuster painkiller Vioxx because of its link to heart troubles. By removing that compound early, Merck lowered my estimate of its intrinsic value, taking its previously fairly valued stock right along with it. Recently trading hands at $31.30, Merck is still more than 24% below what I paid. Given the company's diminished revenues and profits in the wake of the Vioxx withdrawal, that's a justifiable haircut.
Contrast my experience with Merck to Philip's Inside Value selection of mortgage financier Fannie Mae (NYSE:FNM). Amid all the controversy and scandal clouding the firm, Philip determined the company traded at a deep discount to its intrinsic value. The day that newsletter was published in December, Fannie Mae closed at $69.89 per share. After publication, bad news from the scandal continued to buffet the company, including news of a potential $9 billion earnings restatement and the forced resignation of the firm's then-CEO and CFO. Yet in the wake of the continuing bad news, Fannie Mae's stock managed to hold steady, closing yesterday at $69.70 -- mere pennies below its Inside Value price.
The large margin of safety is providing price protection in spite of the continued bad news striking the firm. Even last night's surprise dividend cut sent the shares down to only $68.25 in after-hours trading, just 2.3% below Philip's recommendation price. Dividends are powerful signaling devices, and any unexpected dividend cut can send shock waves through the market. For those fearing the worst from this announcement, take heart. Investors need only look back to Eastman Kodak's (NYSE:EK) late 2003 dividend cut and the buying opportunity it created in that company.
And on the upside...
As well as providing downside protection, there's another benefit to the margin of safety: the opportunity for potential market-beating returns on the upside. Remember that the margin of safety represents a discount to the price where an investor believes a company should be trading, based on its fundamental financial data and prospects. Companies often trade at discounts to their intrinsic values when bad news abounds, such as lowered expectations for future growth, missed earnings numbers, large-scale lawsuits, and other legitimate business issues.
If and when the bad news subsides or gets replaced by positive information, the pricing pressure usually lifts, and the companies' stock prices can rebound -- returning to a number closer to the firm's intrinsic value.
For example, look at another of Philip's Inside Value picks, door manufacturer Masonite International (NYSE:MHM). Trading at $25.12 when it was recommended last October, the company recently closed at $33.28. It's up 32.5%, primarily because of an unexpected bit of good news -- an all-cash buyout offer from Kohlberg Kravis Roberts. Now that the offer is on the table, the company's upside is limited and its margin of safety eliminated, but a nice profit accrued to investors who followed Philip's recommendation.
These benefits from value investing can be achieved only if the companies being considered and purchased are truly values, rather than value traps (companies that appear cheap on the surface but whose businesses are weaker than initial investigations reveal). Even legendary investor Benjamin Graham likened value investing to playing roulette, albeit with the casino's odds rather than the gambler's. There is no assurance of success with any given investment, but with the margin of safety in the investor's favor, the probability of overall success increases across a well-diversified portfolio of value-priced companies.
Turning the table
To assure the odds remain in the value investor's favor, that investor must be conservative in estimating intrinsic values. Any valuation methodology can be influenced by the investor's own biases, and it's far too easy to be overly aggressive in forecasting the future (see my recent article Controlling the Carnage for some bloody examples). No matter what technique an investor chooses for determining a company's intrinsic value, it helps the investor find potential superior returns only if that model presents a value that is realistic, or even a bit pessimistic. For my personal portfolio, I primarily use a combination of the dividend discount and discounted cash flow models, although I have been known to dabble in potential book value bargains.
With Inside Value, Philip has done a fantastic job of determining intrinsic values and coming up with sufficient margins of safety to protect investors. The best performer of his selections so far has been telecommunications giant MCI (NASDAQ:MCIP), recently trading at $19.23, up 38.9% since his recommendation. On the flip side, the worst performer so far has been payment services company First Data (NYSE:FDC). Recently trading hands at $41.31, it's 3.5% below the price it traded when it first appeared in the newsletter.
Although First Data is the lowest performer among the selections at the moment, things can change quickly. The last time I saw a company trading at a significant discount to Philip's Inside Value price, it was pharmaceutical distributor Omnicare (NYSE:OCR). That deep discount was a mistake the market quickly rectified, recently bidding Omnicare up to a price of $33.32, some 12.9% above Philip's price.
By using conservative intrinsic value estimates to determine what a company is worth, investors can place a number where they rationally believe that firm should be trading. By buying only at prices below that value, investors set themselves up to be the casino running Benjamin Graham's roulette wheel, rather than the gambler wildly speculating on a wing and a prayer.
Like the idea of having the casino's odds rather than the gambler's? A free trial of Motley Fool Inside Value is just a click away.
Fool contributor Chuck Saletta owns shares of Merck and Omnicare. The Motley Fool has a disclosure policy.
