Focus on the Margin of Safety

 | Dec 12, 2013 | 5:30 PM EST
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I am going to stick with the theme of stocks to avoid for a couple of days. I am not in the market prediction business and will be the first to tell you that I have no clue where the stock market will go from day to day, week to week or month to month. I am, however, a pretty observant fella and a look around tells me that the market is not particularly cheap at this moment in time.

I have talked about some of these measures, including the median appreciation potential of the Value Line Universe, market cap to GDP, the Tobin Q ratio and even the much maligned Schiller PE ratio. All of these are levels indicate that the market is approaching a point where there is just not a lot of juice left in stocks going forward.

There are not a lot of bargains around right now, which supports my cautious stance. Plus, some really smart and successful people, including Seth Klarman, Carl Icahn and Sam Zell, have expressed cautious opinions on the stock market as well. This is not a time to be pushing out the risk curve and owning stocks with little or no margin of safety. Permanent impairments of capital are painful and in 2014 I think avoiding big losses will be an important part of the making money equation.

The following stocks are not particularly cheap on an asset basis and have poor F-scores, which indicates the companies' operating and financial conditions are worsening. I noticed right away that a bunch of the oil-and-gas master limited partnerships (MLPs) are on the list right now. Income seeking investors have bid these shares up in spite -- even though the underlying fundamentals of the business are not that great right now. Investors should probably avoid MLPs such as Cheniere Energy Partners (CQP), ONEOK Partners (OKS), Williams Partners (WPZ) and Western Gas Partners (WES), as they all have very low F-scores and trade well above the asset value.

Since the car business is generally considered to be doing pretty well right now, I was surprised to see shares of Carmax (KMX) on the list. The company is showing some year-over-year growth at Carmax but the over financial condition merits an F-score of just 2. The used car business is cooling off and new car sales are picking up as the economy improves and dealers resort once again to "fog a mirror" financing. Trading at 24x earnings and 3.6x book value, the stock is not even close to cheap. So I see no reason to own the shares right now.

I was a pretty big fan of Forest Labs (FRX) back in 2009 and 2010. At the time, the company was very cheap, based on assets and earnings but this is no longer the case. Carl Icahn has gotten involved in the stock and a strategic reorganization and headcount reduction has been announced. The stock is now trading at more than 2x book and over 20x the projected profits for next year. The company earns an F-score of just 3, and there does not appear to be much upside left in the stock. It is time to part company with the shares if you own them -- and resist the urge to buy more at this valuation level.

You would think that business would be picking up for Fastenal (FAST). After all, the construction business has been improving. But people seem to be buying their nuts, bolts and other fastening products form someone else. The company is seeing tepid sales and earnings growth and overall conditions earn the company an F-score of just 3. Trading at 30x earnings and 7x book value, the stock is not cheap and there does not appear to be a margin of safety in the shares. There is simply no compelling reason to own or buy the stock at this level.

I have no clue what the market will do overall in 2014. I do know that owning vulnerable stocks is a bad idea no matter what the market conditions are. When you have prices that are at the high end of historic valuations and a lot of very smart people are sounding the alarm, it is an even worse idea.

Focusing on the margin of safety is going to be a key to success next year. Avoiding stocks that have the potential to cause a permanent loss of capital is going to be a crucial component of any investment decisions made over the next year.

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