Margin of Safety Still Matters

Defining a Wonderful Company

In previous posts, I described the kind of situations that I’m looking for: wonderful companies at wonderful prices.

There are many examples of this phenomenon in markets. Defense companies with outstanding long-term track records were available at compelling deep value multiples in 2011 when the US government briefly pretended that it found fiscal discipline religion.

Apple was available at a 10 P/E in 2013 and 2016.

Domino’s pizza was available at deep value multiples in the early 2010’s. The same is true of Mastercard.

I’ve also provided examples of value investors who identified these opportunities, so you can’t say “Yes, but no one could have predicted that.”

The way I see it, if you can find a company with a wonderful track record and you can buy it at a compelling price – the odds are strong that it will work out.

What’s a wonderful company? It’s a company that has an outstanding track record. Their business is predictable. Margins remain relatively consistent. They have a track record of maintaining high returns on capital without the use of heavy leverage. They have a strong moat and would be difficult to compete with. A few punks with laptops can’t disrupt it. They’ve been through many economic cycles and they’ve survived. It doesn’t take a leap of imagination to envision positive long-term growth prospects (i.e., people will continue to order take out pizza on Friday nights, Mastercard’s volumes will increase as we abandon cash, Apple users like their phone and will replace it every two years, etc.)

I used to think it was hard to identify these companies but I no longer think that’s the case. It doesn’t take a genius to figure out that Coca Cola and Colgate have formidable moats and good businesses, for instance. I also don’t think it’s that hard to see that tire companies, video game retailers, steel companies, and airlines (all of which I’ve invested in) are bad businesses.

A wonderful company is the kind of company that I can put my money into and don’t have to watch the price every day and hold my breath whenever I read a K or Q. I don’t want to have to worry about where we are in the economic cycle. I know Howard Marks says you can “master the market cycle,” but so far the market cycle has mastered me.

A wonderful company is the kind of company that I don’t have to sell after a bad quarter (because it might be a sign that everything is about to fall apart for them) or when the stock doubles (because it’s now a no-growth business trading a highish P/E).

I’m tired of investing in no-moat bad businesses and living through that kind of emotional turmoil, praying I’ll be able to unload it at a higher price in the future.

It’s a totally valid style of investing, but it’s just not for me.

I want to own the kind of company where it wouldn’t be a big deal if the market closed down for 10 years and I couldn’t sell. I highly doubt that I will actually hold these stocks for 10 years – but that’s the way I want to think about it before I buy it. If I would be terrified to be locked in for 10 years, then it probably doesn’t make sense to invest in it at all.

I don’t want to have to figure out some complicated sum of the parts situation. I don’t want to have to pray that an activist comes along and saves me.

I’m not looking to identify a cyclical trough in an industry and sell at a top. I don’t want to flip something after 6 months or a year and act like I’m holding a hot potato.

This is valid approach, but I have failed with this approach, so I’m trying something different.

Does price matter?

With all of that said, I still consider myself a deep value investor and only want to buy things trading at a compelling margin of safety.

I want to pay bargain basement multiples. I’m not going to do a bunch of mental gymnastics and put together a DCF that crashes Excel to find a margin of safety. I want it to be obvious.

Many people are perplexed by the fact that I demand such a low price. Why restrict myself to EV/EBIT situations around 10x?

After all, for the last 10 years, price hasn’t mattered much. You could buy a wonderful company at any price and make out okay. In fact, the people who sell wonderful companies when the prices get silly are often mocked. #Neversell, as they like to say.

I disagree with this. Price does matter. Simply because it hasn’t mattered throughout the current bull market does not mean that this environment will last forever.

It is a mistake to buy a wonderful company and not care about the price and history has taught these lessons repeatedly.

The Nifty Fifty Example

The Silent generation encountered this in the early 1970’s with the Nifty Fifty.

The Nifty Fifty were mostly outstanding companies. They checked all the boxes for a wonderful company. High ROIC. Strong long-term operating history. They could easily survive a recession. It didn’t take much imagination to envision continued growth.

In fact, most of them continued to be outstanding performers over the very long run. Most of them are still around and have exceptional long-term track records. Procter & Gamble. McDonald’s. Coca-Cola. Philip Morris. 3M. Walmart. American Express.

If you bought and held these Nifty Fifty stocks for 20-30 years, things worked out for you even though you paid a high price. Jeremy Siegel makes this point.

As Warren Buffett likes to say, time is the friend of the wonderful business. The Nifty 50 are proof of that.

Of course, no one actually buys and holds stocks for 30 years.

What happened from 1972-1982 was a different story: multiple compression. Multiple compression is when the price/fundamental ratios goes down. It’s an ugly situation where the business can continue to succeed, but the price suffers as the multiple declines. It’s a foreign concept to modern investors, but it happens.

Lawrence Hamtil wrote an excellent piece about the Nifty Fifty here.

Hamtil’s piece breaks down many of the track records of these companies for 10, 20, and 30 years.

While many of these excellent companies went on to have excellent 20 and 30 year returns (because time is the friend of the wonderful business), they delivered very poor results over the next 10 years from 1972-82.

Coca-Cola (the textbook example of a wonderful company), went on to deliver a 11.83% CAGR over the 20 years from 1972-92, but for the 10 years from 1972-82, is delivered a negative CAGR of 6.93%.

Coca-Cola continued to grow from 1972-82, but it didn’t matter. Multiple compression crushed the stock. It fell from the lofty heights of a 47.6x P/E multiple.

The same thing happened to Disney, another textbook example of a wonderful company. Disney – which traded at an 81x P/E in 1972 – delivered a -3.78% return from 1972-82. Because time is the friend of the wonderful business, it delivered a 10.81% return if you held through 1992, but who actually did that?

Everyone says their time horizon is long, but no one in the real world actually holds stocks that long. Everyone overestimates their real risk tolerance and time horizon.

This also assumes that during the Nifty Fifty you actually picked out the right companies. There were some that turned out to be long-term duds. Polaroid and Sears were also Nifty Fifty stocks, for instance.

The 1990’s

The same thing happened in the 1990’s.

Many people’s memories of the 1990’s bubble are foggy. They think it was all IPO’s like Pets.com. They think it was all cash burning garbage.

Modern FANGM investors scoff at comparisons of today’s great companies to the garbage bin of the 1990’s dot com craze. Google is certainly not a Pets.com, for instance.

The thing is: the bubble companies of the late 1990’s weren’t all garbage. The late 1990’s bubble included many exceptional companies and went beyond technology stocks.

Coca-Cola was one of them. In 1999, Coca-Cola traded at an EV/Sales multiple of 8x. The EV/EBIT multiple was 30x. From 1999-2009, it continued to grow earnings and sales, but it didn’t matter for the price of the stock. The EV/Sales multiple declined from 8x to 3x. The EV/EBIT multiple compressed from 30x to 10x.

The stock was essentially flat from 2000-09, delivering a .7% CAGR. The business continued to perform, but it didn’t matter for the investor in the stock.

Microsoft is another example. Like Coke, Microsoft grew its business from 1999-09. Revenues and earnings steadily increased. They maintained high returns on capital. Their moat wasn’t breached. However, the stock was essentially flat during the period, returning a .64% CAGR.

Wal-Mart wasn’t exactly Pets.com, but it still participated in the 1990’s bubble. In 1999, it traded at an EV/EBIT multiple of 40x. From 1999-09, it continued growing. The return wasn’t as bad as Coke and Microsoft, but still lackluster: only 3.63% and flat for most of the decade.

Some would say that this multiple compression was reflective of reality: two recessions, for instance.

I think that’s a little nuts. I don’t think it takes a genius to figure out, for instance, that a 30x or 40x multiple is high. Nor does it take a genius to figure out that Coca-Cola is probably going to make it through the Global Financial Crisis and people will continue to buy their products at the supermarket.

I don’t think wildly changing multiples are reflective of economic reality, which is what the EMH crowd would say. I think they’re reflective of the fact that people are crazy, Ben Graham was right, and the gyrations of the stock market are best described by the manic depressive mood shifts of Mr. Market rather than the elegant economic theories taught in classrooms.

Anyway, as history has proven, an exceptional business can deliver poor returns if you pay too high of a price. Investors in the 2000’s and 1970’s found this out the hard way.

This also assumes that you actually identified a wonderful business. What if you’re wrong? What if you think you’re buying Coca-Cola, Wal-Mart, and McDonald’s in 1972, but you’re actually buying Kodak, Sears, and Polaroid?

Many of the ‘buy wonderful businesses at any price’ investors will also console themselves in the work of Jeremy Siegel, who points out that if a Nifty Fifty investor held through the pain of the 1970’s, that they eventually made it on the other side okay. I think this is very unrealistic. My guess is that most people didn’t hold, and likely sold after a decade of poor performance.

Margin of Safety Matters

Buying a great business isn’t enough. A great business can easily experience multiple compression if bought at too high of a price.

Moreover, there are no guarantees that a great business will stay great. What if that dynamic changes? It’s one thing to buy a Microsoft at a high P/E and earn flat returns for 10 years and then make out okay after 20, but what if it’s not Microsoft? What if the business looks great today, but still falls apart?

I think you can use some common sense to identify great businesses, but I also think it’s possible you can be wrong about a few of them.

Multiple compression and the possibility of an error about the business are why I think a great business should only be purchased with a substantial margin of safety.

In my view, a portfolio of great businesses purchased at bargain basement multiples has a high probability of succeeding over the long run. If I buy at a cheap enough price, if the business doesn’t succeed, at least I didn’t pay too much. If the business succeeds, then I’ll get multiple appreciation on top of the performance of the business and the result will be outstanding. Meanwhile, multiple compression isn’t high on the list of concerns when bought at a 10x EV/EBIT multiple.

The darlings of the current era are probably wonderful companies. Most of them, anyway. I think the prospects of Google and Facebook are better than that of Netflix and Tesla.

But even in the case of Google and Facebook, I don’t think investors are thinking about the following questions: What if their multiples compress? What if we’re all wrong about the outstanding nature of these businesses and something happens where they cease to be wonderful companies? If we’re wrong about the business, multiple compression is going to be severe. If we’re right about the business, multiple compression can still result in a lost decade.

Even though price hasn’t mattered for the last 10 years, I still think price is important.

I think it’s a bad idea to abandon margin of safety and “never sell.”

Call me old fashioned: margin of safety is still an important concept.

Random

Boom Like That: It’s about the architect of a Nifty 50 company, Ray Kroc

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