Kent Lucas here once again – first off, let me say thanks for all the positive feedback sent in by Taipan Daily readers.

It looks like I’ll have the chance to share with you the keys to long-term equity investing, stock picking and wealth creation on a regular basis moving forward. I truly look forward to sharing my thoughts with you...

Secrets of Value Investing Success

For the next few weeks, I’m going to cut to the chase and dig into the “secrets” of successful long-term value investing: How I go about picking stocks with the greatest possible odds of protecting and growing your wealth. I’m going to share with you what’s behind my process and hard work. The principles you’re going to read about drive the activities I spend almost all of my waking day doing – the research, the analysis, the number crunching, the phone calls, etc. – and represent what I have used throughout my professional money management career for stock picking success.

And of course, it’s not just “my” approach – these criteria are at the heart of the methodology that the greatest value investors use. Now, some legendary value investors will give more weight to some concepts than others... or might have developed their own unique process and methodology... but believe me, no matter how you look at it, these are at the core of value investing success!

Introducing the Significant Six

I’m calling these core concepts the Significant Six. Understanding and incorporating these six factors into your stock picking efforts can almost certainly help make you a better investor. And even if you don’t have the time or experience to spend all day analyzing high-quality investment ideas – that’s what guys like me are here for – you can trust that I’m heavily scrutinizing all present and future Safe Haven Investor picks largely based on how they stack up against these six factors.

Again, speaking as a highly trained market professional, use of the “significant six” has led to great investing results over the years. And just as importantly, I believe these ideas are geared toward your long-term investment goals too. Potential investments must excel in most, if not all, of these categories (with a few rare exceptions).

Now, the Significant Six can broadly be broken down into two groups of three. The first is more relevant for wealth protection, i.e. “not losing money.” The second is more generally focused on wealth creation, that is, generating outsized investment returns. As you will see, these categorizations are a generalization, but I think it’s a good framework that will make things easier to understand.

To keep your attention, today I’m only going to talk about one Significant Six concept, taken from the wealth protection side of the ledger. It also happens to be one of the most important value investing concepts of all.

“Margin of Safety”

Margin of Safety is one of the oldest and most respected concepts of investing – and for good reason. It was first introduced by the “founding fathers” of value investing, Ben Graham and David Dodd. And the concept is still at the core of the investing process for the brightest and most successful value investors today, including Warren Buffett (a student of Graham and Dodd), Seth Klarman and Mario Gabelli, to name a few.

The margin of safety concept entails buying stocks (or anything else for that matter) at a price that is far less than what the true, or intrinsic, value happens to be. (“Intrinsic value” is a common value investing term.)

After the market extremes of the past few years, I’m sure we all know that sometimes, a stock price can diverge from the true value or rationally assessed worth of the underlying business – and that’s what creates opportunities for us to make money. When the disconnect is very wide – specifically, when the stock price or current market value is meaningfully lower than what I perceive the company to actually be worth – that’s when the margin of safety comes into play.

Here’s a key way to think about it. The further away (i.e. lower) a stock price moves relative to what the logical, rationally assessed value should be, the less risk remains in terms of how much farther the stock can drop. It’s the genuine value of the underlying business that provides the margin of safety – because if the stock price fell too far, that would allow the opportunity for someone to buy a good business at pennies on the dollar. Thus, having a strong sense of what the business should be worth is a way of minimizing investment risk... a vital concept when looking at long-term returns and thinking about retirement assets.

Now we come back around to “intrinsic value” again. In the example I have for you below (a few paragraphs down), the stock is trading at a 30% discount from its intrinsic value, so it has more “cushion,” and less downside room to fall, than a higher priced stock with a smaller margin of safety would offer. And if the downside is limited, then by definition the upside is greater because, at some point, the stock should regain its value (i.e. adjust upwards to be more in line with the true value of the company).

Valuation and Intrinsic Value

At the heart of the margin of safety concept is Valuation. I’m sure you have heard this term bandied about, given how important it is to stock picking. When I talk about a good margin of safety, I’m talking about a stock that has a very attractive (e.g. low) valuation relative to what I think the business is worth.

Each investor has different metrics or combinations for performing a valuation analysis. For example, some metrics considered are the future earnings stream (price-to-earnings ratio), expected cash flow (e.g. enterprise value or EBITDA), expected dividend returns (e.g. the dividend discount model), and book (e.g. tangible asset) value. All these are powerful valuation metrics used to determine intrinsic value.

I personally like to look at normalized earnings, cash flow and sales. Actual earnings (slightly different than normalized earnings) have a lot of historical context, but can be misleading depending on the nature of the industry. “Normalized” earnings, in contrast, are essentially a company’s trend-line projectory of earnings through all the ups and downs of the economic cycles. Cash flow analysis can be very reliable also. And in certain industries, looking at asset values or doing a “sum of the parts” analysis is useful too.

Real World Example: Caterpillar

So let’s look at a real world example, shall we?

We all know of Caterpillar (CAT:NYSE), the premier global construction and machinery manufacturer. The global downturn crushed economically sensitive heavy industrial companies like Caterpillar (whose earnings actually held up relatively well for being in such a cyclical business).

Today I won’t get into Caterpillar’s fundamentals, its stock performance, or whether the stock is worth buying at today’s price levels. Rather, let’s just explore what I would look for in trying to calculate Caterpillar’s margin of safety.

In addition to normalized earnings, I look at Caterpillar’s price-to-sales ratio, which is a less volatile measure than earnings and is good for comparative purposes. And enterprise value/ EBITDA, is a solid way of measuring the total value of the company relative to how much cash it is generating.

Cash is very important on its own, and I will discuss this important valuation tool separately at a later date. But for now remember that “Cash (flow) is king.” And finally, I estimate Caterpillar’s intrinsic value based on the classic (but less than precise) dividend discount model.

 

Margin of Safety Analysis: Caterpillar

Implied Intrinsic Value Price

Current

Market Value

Margin of Safety

(Potential Upside)

Normalized Price/Earnings  

$75

$57

31%

Price/Sales

$71

$57

25%

Enterprise Value/EBITDA

$71

$57

25%

Dividend Discount Model

$75

$57

31%

Source: S&P, Credit Suisse, KJL estimates

Again, I’m just using Caterpillar as an illustration with rough estimates of key valuation metrics. And yes, they are just that: rough estimates with no investment horizon (purposely omitted).

Hopefully via this quick and dirty example, you’ve gotten a fair sense of what goes into assessing a company’s margin of safety, and how that concept translates back to the downside risks associated with buying a stock.

More to Come

Well, I hope you learned something in the past few minutes that will help make you a better investor and a more successful stock picker. I also look forward to telling you about the other five components of the Significant Six in the weeks to come. As Taipan Daily readers, you are also getting a small preview of what I’m about to reveal to Safe Haven Investor subscribers. I’m still finalizing the format, but think of the Significant Six as an investing checklist for Safe Haven Investor picks to come.

 

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