The Importance of a Margin of Safety
The danger with this approach is that, if taken too far as human
psychology is apt to do, is that any basis for rational valuation is
quickly thrown out the window. Typically, if you are paying more than
15x earnings for a company, you need to seriously examine the
underlying assumptions you have for its future profitable and
intrinsic value. With that said, a wholesale rejection of shares over
that price is not wise. A year ago, I remember reading a story
detailing that in the 1990s, the cheapest stock in retrospect was Dell
Computers at 50x earnings. Thats right had you bought it at that
price, you would have absolutely crushed nearly every other investment
because the underlying profits really did live up to Wall Streets
expectations, and then some! However, would you have been comfortable
having your entire net worth invested in such a risky business if you
didnt understand the economics of the computer industry, the future
drivers of demand, the commodity nature of the PC and the low-cost
structure that gives Dell a superior advantage over competitors, and
the distinct possibility that one fatal mistake could wipeout a huge
portion of your net worth? Probably not.
The Ideal Compromise
The perfect situation is when you get an excellent business that
generates copious amounts of cash with little or no capital investment
on the part of the owners relative to the profits at a steep discount
to intrinsic value, such as American Express during the Salad Oil
scandal or Wells Fargo when it traded at 5x earnings during the real
estate crash of the late 1980s and early 1990s. A nice test you can
use is to close your eyes and try to imagine what a business will look
like in ten years; do you think it will be bigger and more profitable?
What about the profits how will they be generated? What are the
threats to the competitive landscape? An example that might help: Do
you think Blockbuster will still be the dominant video rental
franchise? Personally, it is my belief that the model of delivering
plastic disks is entirely antiquated and as broadband becomes faster
and faster, the content will eventually be streamed, rented, or
purchased directly from the studios without any need for a middle man
at all, allowing the creators of content to keep the entire capital.
That would certainly cause me to require a much larger margin of
safety before buying into an enterprise that faces such a very real
technological obsolesce problem.
