There are always dangers for your portfolio in the stock market.
Valuation error, economic headwinds or incompetence/greed by management, even overpaying for your stock.
Most investors concern themselves with gazing into the future.
YOU KNOW THAT IT’S A BIT MORE SOPHISTICATED THAN THAT.
A value investor is someone who determines their own price to intrinsic value ratio derived from databases and screeners, news sources and the financial statements and annual reports going back a decade.
At least that’s what should happen.
So let’s get straight into ways you can give your portfolio a margin of safety.
Step 1: Find Out What The Company Is Worth
The first step in the valuation process is to find out what the company is worth. The worth (intrinsic value) of a company is derived from balance sheet analysis for old school value investors who take this stuff seriously.
For example, what I learned from Walter Schloss was that if a value investor does rely on balance sheet analysis such as tangible asset value, then it is essential that the tangible assets such as plant and machinery are assessed to see if it is old or new because this will have a bearing on it’s true value.
It is also essential to navigate the annual report and notes to the accounts to see if there any off balance sheet liabilities – these are liabilities that the company faces but have not listed on the balance sheet.
Step 2: Review The Historical Earnings Record – 10 Years’ Worth!
Intrinsic valuation does not stop at the balance sheet it will also involve a review of a company’s history of earnings.
Use annual earnings only and ignore quarterly figures. Let Wall Street ‘churners and burners’ gorge themselves on short term data.
As value investor, all you have to worry about is answering the following question by looking at the EPS figures:
HOW WELL OR POORLY HAS THE COMPANY GROWN EARNINGS IN THE PAST?
You will more than likely find that the historical record of earnings will not show a smooth upward trajectory. This is fine so long as earnings have grown over the long term.
An example of how to assess the historical earnings record is presented in the table below which is a snapshot from this post and focuses on the earnings picture of four large cap tech stocks.
EPS (diluted) 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Amazon -0.39 0.08 1.39 0.84 0.45 1.12 1.49 2.04 2.53 1.37
Apple 0.10 0.36 1.56 2.27 3.93 5.36 9.08 15.15 27.68 44.15
- - - - - - - - - 0.43
0.41 0.41 1.46 5.02 9.94 13.29 13.31 20.41 26.31 29.76
EPS % from previous year 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Amazon - - - -39.57 -46.43 148.89 33.04 36.91 24.02 -45.85
Apple 5.56 273.68 339.44 45.51 73.13 36.39 69.40 66.85 82.71 59.50
- - - - - - - - - -
925 0.00 256.10 243.84 98.10 33.70 0.15 53.34 28.91 13.11
EPS growth rates % Previous 3 yr avg up to 2002 Previous 3 yr avg up to 2011 10 yr avg
Amazon - -2.76 -
Apple -55.66 69.41 85.81
- - -
- 30.76 93.71
*All data fields are from ADVFN
Presenting and then reviewing annual EPS data in this way makes it easy to make intelligent conclusions about a company’s earnings from its historical record.
Making earnings predictions is notoriously difficult.
Stick to what you can find out about a company from its past record instead going back a decade or more. Then you can bring your analysis together and think about the long term prospects of the company, which is not limited to earnings.
Following step 1 and step 2
should will give you an approximation of intrinsic value, which only leaves..
Step 3: Determine If The Current Price Is Low Enough To Represent An Adequate Margin Of Safety
Is today’s market price least at or below the intrinsic value as you determine it?
Is the company’s’ P/E ratio high/low as compared to:
- The general market?
- Other companies in it’s industry/sector?
The basic message here is: do not pay a high or even a fair price for your company.
Pay only a low price in relation to the intrinsic value of the company as you determine it.
Stick consistently to this 3 step process by becoming a creature of habit by not allowing overpriced companies into your portfolio; seek a large margin of safety.
A margin of safety is necessary because valuation is an imprecise art, the future is unpredictable, and investors are human and do make mistakes – Seth Klarman
I whole heartedly concur.
All the best