Focus on the Margin of Safety

 | Feb 03, 2014 | 11:30 AM EST
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The Super Bowl has finally come and gone and it was quite a game. No one saw that coming, not even the professional gamblers and odds makers who spent hours running the numbers through their computers and spreadsheets.

The Broncos were actually a slight favorite of 2.5 points and the total points scored were forecast to be less than 47. The Seahawks scored more than by themselves and the Broncos lost by 35 points. No one, even the most ardent Seahawks fan, predicted this outcome.

We can make all the guesses we want, but it is all just a wild guess until they tee the ball up and play the game. Lots of real pretty hotels and casinos have been built, based on the fact that is a difficult proposition to pick the winners on a consistent basis.

It is pretty much the same in the financial markets. We just came through the year- end prediction season where everyone and their cousin had predictions for what the market would do in 2014. The same game is played pretty much every morning as the talking heads and gurus offer daily prediction about economic releases, earnings numbers and the markets themselves.

They are wrong with shocking frequency as these things are simply not knowable in advance. There are just too many variables and possibilities that will affect the market prices during any given day. Predicting market levels is a foolish and usually expensive game to play for investors.

Leave the predicting to others and focus on what the greats like Benjamin Graham, Warren Buffett and Seth Klarman have already told you is the single most important concept in investing. The margin of safety should be your first concern when it comes to investing in the stock market.  Focusing on two questions can allow you to use the concept of margin of safety to protect yourself from bad markets and see profits measured in multiples rather than percentages in the good time.

The first concept is to determine if the stock is cheap? Rather than deal with the land of earnings, which are easily manipulated, or forecasts of profits which are usually wrong, I prefer to focus on assets. I take it one step further and use tangible assets like cash, securities, buildings, inventories, machinery and other stuff than can be touched, bought and sold.

Intangible assets like goodwill may have value; they may not. I value them at zero and if they turn out to have some worth, then it is just a bonus. I want to buy shares in a company as a steep discount from the value of the tangible assets minus any debt for other obligations. This creates the first level of a margin of safety as no matter what the market does I own assets that are worth more than I paid for them.

The second question that I ask is simply whether the stock is safe. For the majority of stocks, this question can be answered using two tools developed by the academics. These tools make the analysis of financial statements a lot easier than it was back in the days of using stock guides and waiting for the financials to arrive in the mail.

Edward Altmans Z-score has been around since 1968 as a way to measure financial solvency of non-financial companies. A score of 2.99 indicates a strong company while a score below 1.81 was a death zone where financial failure was possible and even probable.

The other tool is, of course, the Piotroksi F-score.The model was introduced in 2000 and works very well at spotting favorable conditions and improvements in the financial statements. This gives us a good indication of both safety at the company level and the potential for a higher stock price. The 9-point scale has become one of the best tools in my stock picking arsenal over the years and using it has had a dramatic positive impact on results.

It is a simple task to sit down and review all the thousands of stocks to a universe of companies that trade below tangible book value and earn high Z and F scores. When I run this screen today I see some of the stocks I have mentioned in the recent pass like Richardson Electronics, (RELL), Seneca Foods (SENEA) and TransWorld Entertainment (TWMC) that are both safe and cheap and are solid candidates for long-term investors regardless of market action.

The bonus to all this is that there are more safe and cheap stocks after prices decline and fewer after sustained advances. Focusing on the margin of safety acts as a natural timing mechanism that forces us to buy fear and sell greed.

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