In 1949 Benjamin Graham, the mentor of Warren Buffett, wrote a famous book called The Intelligent Investor. In it Graham wrote that the three most important words in investing are “margin of safety.” But up to now the idea of a margin of safety has been a vague idea with no clear steps to implement it. Extensive research and back testing at Conscious Investor has changed this. A carefully calculated margin of safety is an exciting addition to Conscious Investor and the Conscious Investor Wizard. With the introduction of an automatic margin of safety, subscribers can have even more security and confidence in the search for great companies selling at profitable prices.
Prudent inventors require a margin of safety before investing as a protective buffer against market volatility and changes in business performance. It is like analyzing the stock under a worst case scenario. This is particularly important at the current time.
Users of Conscious Investor know that it is easy to modify the input variables in the Scenario Analysis and in “Step 3: Price” of the Wizard to incorporate a margin of safety. Now it is even easier since there is an automatic margin of safety. It is implemented by clicking on the Safety button. When you click on the Safety button, an automatic margin of safety is introduced for the forecast of the PE ratio and the forecast of the growth rate of the earnings per share.
It is useful to think of the implementation using the Safety button as a carefully constructed stress test. The potential investment is tested under extreme conditions. If after this test it is still has all the signs of an attractive investment, then we can more confident about making the purchase.
The goal is the same whether you use the automatic margin of safety built in to Conscious Investor or your own settings. It is to find investments that will give a satisfactory return even allowing for a downturn in performance of the business (as seen by the earnings not growing as fast as expected) or a decrease in market perception or confidence (as seen by the PE Ratio being lower than expected). In both cases it is now even easier to implement these “safety first” criteria into your investing decisions.
The actual calculations behind the Safety button are based on careful logic. They have also been tested and refined using thousands of examples. The resulting calculations are complex, but so that you have a general idea of what is involved in the calculations, below is a broad outline of the key steps. The calculations are in two parts: safety calculations for the PE ratio and safety calculations for the forecast of earnings.
Safety PE Ratio Forecasts
The safety level for the PE ratio uses the current PE ratio and the average of the PE ratio over the previous four financial years.
The calculation starts by setting the safety PE ratio equal to the current PE ratio. If the average PE ratio over the past four years is lower than the current PE ratio, then the calculations lower the safety PE ratio in a specified way using both the average PE ratio and the current PE ratio. In the opposite case where the average PE ratio is higher than the current PE ratio, no change is made to the safety PE ratio.
Finally, a mean reversion is used in the downward direction as an extra margin of safety.
The actual function used in the calculation is called PESAFETY.
Safety Earnings Forecasts
The safety level for the forecast for earnings per share uses the historical growth rate of earnings per share, the historical growth rate of sales per share, and the stability of earnings per share to make a conservative estimate of the future growth rate of earnings per share. As an investor, it is less important to make an accurate estimate of growth rate than it is to make an estimate about which we can be confident that the actual growth will equal or exceed it. In other words, we are looking for a worst case scenario or something close to it.
Regarding the three input variables, it is clear why historical growth rate of earnings per share is used since a simple future forecast is that it is the same as the past. The calculations start by setting the safety growth rate equal to the historical growth arte of earnings.
There are two options for the historical growth rate of sales per share; either it exceeds the growth rate of earnings per share or it does not. If sales per share growth is lower than earnings per share growth, then this can act as a restriction on earnings to continue growing at the same rate since for this to happen either the net profit margin would have to increase or the growth rate of sales would need to increase. In this case we use the growth rate of sales to lower the safety estimate of the growth rate of earnings.
In the opposite case where the growth rate of sales exceeds the growth rate of earnings we give less importance to the sales component.
Regarding the third input, namely the stability of the growth rate of earnings, the higher the stability, the more confidence we can have in the historical rate of growth acting as a forecast for future growth rates. To integrate this finding into the safety forecast, the lower the stability of the historical earnings, the lower we make the forecast. (The stability of earnings is measured by the proprietary tool STAEGR.)
Finally, over and above the what was just described, we incorporate an overall margin of safety. This is in two parts: mean reversion in the downward direction and an absolute reduction.
The actual function used in the calculation is called ESAFETY.
DISCLAIMER These safety levels are automatic calculations and cannot take into account all the information you may have gathered about the company. Nor can they allow for your own risk threshold. For these reasons it is important to use them only as an initial guide and that, before making any decisions, you should use your own judgments or advice you may have received from professionals.