Making mistakes is an inevitable part of being an investor. As long as company values are mainly based on future events, this is the way it must be. Unforeseen events, or even just bad luck, can knock the legs out from under even the best analysis.
Acknowledging this fact forms the basis of what is perhaps the most important concept for us as investors, namely the margin of safety. This is the key to finding investments that provide extremely good returns when we get it right, but at the same time limit the losses when we get it wrong.
For Benjamin Graham, considered to be the father of value investing, the main way to ensure a margin of safety is by paying a low price. Buying companies at a solid discount to underlying values means that the bad news is already priced in and investors have a buffer against unforeseen events.
Low price isn't everything
Long time series in the global stock markets also support the message that it pays to buy "cheap". Companies with low valuation, based on book values and earnings, have proven to perform better than the general stock market.
However, a low price tag is not everything. The investor and writer Joel Greenblatt demonstrated in his book The Little Book That Beats the Market that investments based on a combination of low valuation and high return on invested capital deliver better returns than the general stock market. The returns were also better than what pure value and quality-based investments would have delivered in the same period.
An important point arises from this: a low price is not the only way to ensure a margin of safety. A company with a significant competitive advantage can also provide investors with downside protection. A world-leading brand name, strong customer preference or superior distribution can make a company better equipped to deal with unforeseen mistakes and problems. This type of resilience also benefits shareholders of course.
Margin of safety
Graham acknowledged that the potential of future earnings could also constitute a margin of safety. However, he warned against putting too much emphasis on historical figures when it comes to predicting the future. Not least, the market has a tendency to price companies with good prospects so highly that it causes the margin of safety to shrink.
Graham is of course right in saying that companies with extremely high expectations of future earnings are often priced accordingly. Even though the market is not always efficient, there tends to be a reasonably good correlation between expected earnings growth and valuation.
However, the fact that companies are often priced correctly does not mean that they always are. Popularity, psychology and other factors cause prices to fluctuate far more than the underlying values.
One important and relevant element that has changed since Graham's time is the market's time horizon. According to the NYSE, the average time for owning a stock on the US stock market fell from eight years in 1960 to around three months in 2012.
What is the right price?
All things being equal, this should mean that a company's long-term competitive advantage is not fully reflected in the market prices seen by short-term investors, which is thought-provoking.
A hypothetical example can illustrate the point. Imagine two companies, A and B. Company A has a clear competitive advantage and a largely addressable market that means that earnings can grow by ten percent over the next ten years. Company B is also in a position to grow, but by a moderate earnings growth of two percent per year.
Let us assume that A's good prospects mean that one must pay 20 times earnings (P/E 20), while company B is priced at a more moderate 10 times earnings. In order to reflect the risk associated with "high" priced shares, we assume that the P/E of company A will fall from 20 to 15 after we have invested. For company B we assume that the P/E will increase from 10 to 12. This illustrates the effect of a multiple expansion.
In the short term, the price tag that the market puts on earnings is central to the returns achieved. After one year, the investment in company A will have generated a loss of 18 percent, while the investment in company B will have generated a profit of 22 percent.
However, the more time that passes, the better the returns for those who have invested in company A. Although the price (P/E) has fallen from 20 to 15, after ten years, investors can enjoy an annual return of seven percent. The corresponding return for investors who have put their money in company B, where the P/E increased from 10 to 12, is only half that, four percent.
In the long term, the earnings development therefore plays an important role in determining shareholders' returns. Even though the market puts a much lower price on earnings after they have been attained, the end result is still good.
In a world in which investors have an increasingly short time horizon, there is a great deal of evidence that it is possible to find companies that are mispriced from a long-term earnings perspective. Investors who measure their stockholding periods in days, weeks or months do not ascribe much value to the ten-year perspective.
For modern value investors, the discount to a company's underlying value is still a necessary prerequisite for creating excess return over time. However, we are also willing to acknowledge that good quality companies can be worth paying for.