In my last post on margin of safety, I talked about requiring higher margin of safety for companies that I feel uncertain about my judgment of their earnings power. Simply speaking, I would pay 10 times earnings for a highly predictable company. I’ll pay a lower earnings multiple for a less predictable company. But it’s not that simple. Geoff usually tells me business is more like biology than math. In order to understand a company, we need to understand its evolution and corporate DNA. We need to understand the management, and the process that makes the company successful. And we need to judge whether the process can be continued or can be repeated in new markets. All this information can give us clues about the future. At the risk of over simplifying, I would say my investment analysis is the process of examining how each dollar of assets will change in the future and deciding whether there’s enough margin of safety at the current price.
I will save discussions on my process for another day. This post is only about how I decide whether a price provides an adequate margin of safety. And the discussion is limited to earning power of a company’s assets. Margin of safety in net-nets, asset play, etc. is beyond the scope of this post.
Understanding Capital Allocation
Capital allocation is the second factor I look at after earnings predictability. Bad capital allocation can spoil a great business as an investment. Of course I don’t mean companies should not build up cash. To some extent, building up cash is a wise way of using capital. That’s another topic. But understanding capital allocation is critical to reasonably estimating how each dollar of assets will change over time. Capital allocation was what kept me from buying News Corp (NWSA) last summer when the stock plummeted as a result of the phone hacking scandal. NWSA had a portfolio of valuable media assets and I believed the stock was cheap. But Rupert Murdoch has a mixed history of building and destroying value. I also think capital allocation is the reason why Warren Buffett bought shares of Coca-Cola (KO) in 1988 but not before. He only bought the stock after observing the company selling non-core assets and repurchasing shares
Limit Earnings Multiple to Protect My Ignorance about Growth
Phil Fisher was willing to pay any price for a stock. I’m not.
True, growth makes the valuation process complicated. Facebook (FB) may provide a huge margin of safety at the current price if you are highly confident that they can find a way to monetize their user base better. Actually finding that is not enough. Two other variables are how fast and how far. I bought Ebix (EBIX) at 22 times earnings. This is a double-digit grower with 10-year average return on equity of 28%. Perhaps that is another mistake I made. I was too aggressive at that multiple and the level of my knowledge about growth. I fell in love with the company and I forgot my old rule: more margin of safety in times of uncertainty. My uncertainty about EBIX is how fast and how far they can grow. That leads to my second rule: never buy a stock at more than 15 times normal earnings, no matter how fast it is growing, how wide its moat is and how high its ROE is. I’ll pay 15 times normal earnings only when I’m certain that the company is growing profitably and sustainably. An immediate 6.66% return in hand is the protection of my principal. That might be too strict, but that’ll prevent me from making mistakes.
Phil Fisher’s Margin of Safety
The last subject is abstract. It’s the organization. That’s what Phil Fisher looked at. He didn’t just want companies that had products or services with significant growth potential. He also looked for an organization with the ability to repeat current success in new markets. Once he found such a company, price was not important. The reason is that if the company can double earnings in 5 years and its future prospects remain just as favorable, Mr. Market will pay the same earnings multiple, and he’ll earn a 15% annual return. To Phil Fisher, the organization’s ability to maintain its favorable prospects protected him from multiple shrinkage. That was his margin of safety. He bought great companies like Motorola, Dow Chemical, and Texas Instruments. With hindsight, we can see these companies were able to reinvent themselves, find new products for growth along with changes in the market.
Learning about an organization is my favorite part of the research process. But I never trust my ability to judge an organization. This part is too subject to human errors.
Margin of Safety in Three Levels
In general, there are 3 levels of margin of safety when buying a business. The first is the reliability of past earnings and reasonable capital allocation. The second is the future prospect of current products or services. The third is the capability of the organization. When I’m uncertain about the capability of the organization, I give no value to that third level. When I find it hard to accurately predict growth of a product, I want to buy growth for free. In those cases, I stick to level 1.