Unlike bonds, equities have no contractual obligation to be owed anything. Equity investors are last in line in bankruptcy and are not even guaranteed a dividend if the company makes money. Because of these risks, equity investors must find a margin of safety before buying.
Each industry and company have different characteristics that make identifying that safety level different. Different growth rates, profit margins, and debt levels make the margin of safety unique for every company. Finding the margin of safety for the company you are looking to buy is the duty of the enterprising investor. Below is a chart of the value investing firm Hotchkis & Wiley's Allstate (ALL, Financial) holdings.
For some companies it is easy to identify value based on assets. It would be like finding a pair of brand new Jordan brand shoes for $15.00. Your knowledge of the Michael Jordan brand tells you the real value of those shoes are near $140. If you are able to find an authentic pair for $15.00, you know you found a bargain.
When investing in a company, the Jordan shoes would be the company assets we are acquiring. For a retailer, those assets include inventory. A technology company would have intellectual property. A Real Estate Investment Trust has property as its asset. An insurance company such as Allstate has insurance policies and investments as their core assets.
For companies with easily identifiable core assets, one can estimate a margin of safety. By plotting the level of those assets next to the price the stock market is charging, one can find areas of opportunity. Naturally, if you were looking to buy something, you want to pay the lowest price. When considering Allstate as an investment, we would look for areas where those assets are priced at a discount. The green line below is the total asset value of Allstate. The blue line is market capitalization.
The lower the market capitalization is compared to total assets, the bigger discount an investor is getting on those assets. This spread is the margin of safety. Understanding how wide the spread gets and how frequently it occurs will assist in protecting against the risks in equity investing. Shown above, one should notice the discount on Allstate assets in 1995 and 2009-2011. These times were difficult years for Allstate. Those times offered the enterprising investor an opportunity to buy.
For those buying Jordan brand shoes for $15, the chart below depicts the $140 real asset value line and margin of safety between the price paid. Equity investing is very similar. Identify the asset value and compare it to the price. The wider the margin the better the opportunity.
Have you identified the margin of safety in the company you are looking to buy?
Thanks to Gurufocus for providing the interactive chart features.
