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Welcome to USAGOLD's "Gilded Opinion" pages. We invite you to browse our index of outstanding gold-based commentary.
Storm Watch:
Margin of Safety
(Jan 18, 2002)
by James J. Puplava / Financial Sense Online
There are many ways to make money in the stock market. Some investors do it by luck, others by intuition, while a few make money by discipline. As this New Year begins and forecasts are drawn, everyone has an opinion as to how this market will play out and where the money will be made. Financial publications, media and many of the stars on Wall Street and in the financial press have definite views. There is a plethora of opinions on the economy and markets, what to buy, what to sell, and when. For investors, the cacophony of words can be confusing and distracting, preventing an investor from making rational decisions. Too much emphasis has been made on the future and what might be, instead of what is and how we got here.
Fundamentals ~ a Bygone Word
Today's markets are driven by news and short-term events. The emphasis is on trading rather than investing. Over the last decade, the markets have gone through a metamorphosis from a market driven by investors with long-term horizons to one dominated by speculators with short attention spans. Hope, hype and spin are more important than facts and analysis. Even views of risk have changed over the last few decades. Financial risk has been redefined. The concern is no longer centered on the business risk of the enterprise. The importance of understanding financial statements and what they tell you about the business is ignored much to the detriment of investors. The emphasis today is on the price of a stock. Everything is price driven. Will the price be up or will it be down today or tomorrow is all that matters.
Everyone is Programmed to Trade
Millions of computer screens in trading rooms and in the homes of investors around the globe are tuned into following the price of everything that can be bought or sold. The price of stocks, currencies, interest rates, bonds, and commodities are all monitored. When prices change, a chain reaction is set into motion. Decisions are made, trading is initiated, and assets are bought or sold without regard to risk or value. "Trade first and ask questions later," has become the modus operandi of the markets. Everyone is looking at prices, waiting for news and ready to react when it occurs. Computer and television screens have replaced the annual report and the art of financial analysis. Like soldiers waiting for the generals to direct them into battle, investors anxiously watch their computer and television screens, and wait for their marching orders.
Volatility and Beta are Everything
The financial media is constantly telling investors where prices are now and where they are headed. Investors know everything about the price of the stocks they own, but very little about the business. This reflects the short-term orientation of the markets and today's definition of risk. Risk has now been redefined in terms of volatility or how much a stock fluctuates in relation to the rest of the market. Academics have reshaped risk and given it new meaning. Volatility is everything. For stock investing, a stock's beta measures a stock's relative volatility to the rest of the stock market like the S&P 500 Index. Beta has become more important. If an investor is willing to take substantial risks, with the implications of risk, volatility, and variability, they buy high-beta stocks. These stocks will rise more sharply than the market and provide a greater return in the long-run. Risk-adverse investors buy low-beta stocks because they are less volatile. When the markets go up, they will go up too, but less rapidly.
A Case in Point: Enron
Unfortunately, beta doesn't tell you anything about business risk. A good example is Enron which carried a beta of 1.05. It was considered a low-beta stock. Enron's stock was close to the market's beta which was 1.0. It was supposed to move up and down with the market. Instead of moving with the markets, Enron moved into bankruptcy. Enron's beta told investors very little about the company's balance sheet risk or the risk of its enterprise. It is ironic that Enron carried a low beta even though it was involved in a high-risk business. The company had metamorphed itself from a stodgy pipeline company into a high-risk trading enterprise that was highly leveraged. In the end, it was the company's high-risk trading strategies and leverage that brought Enron down.
Derivatives and Volatility: The Holy Grail of Finance
If a stock's price and beta have become the dominant force in individual stock investing, a more sophisticated variation of this theme dominates the institutional markets. On Wall Street, volatility has become the bible and the Holy Grail of finance. Volatility has become the be-all-and-end-all of today's financial world. It is what drives institutional trading through financial instruments called derivatives. These complex financial instruments dominate modern finance. They were originally developed as a means to hedge against risk. They began to take on a different role as the result of a formula that was developed in the 1970's. That formula enabled investors to determine what a call option is worth at any given moment in time. The formula is known in the financial world as The Black-Scholes Option-Pricing Formula. The formula began to mutate with probability theory. In the minds of financial engineers, it was now possible to isolate risk, price that risk, and then develop trading models around it.
Around the globe, complex computer
models have been developed to take advantage of every permutation
and possibility of every financial instrument and market. The
world of derivatives has grown in size to a market that now approaches
$100 trillion with seven U.S. banks accounting for over 50% of
that total. They have been used to power the markets with energy,
but they can also cause destruction when they are used for speculation.
Originally they were used to hedge against interest rate and currency
risk. Today, the majority of derivatives are used for just this
purpose. However, they are also used for speculation because derivatives
take leverage to the nth degree. A small proportion of capital
can control a large amount of assets. In the case of Long Term
Capital Management, the firm had $4 billion in equity, nearly
$140 billion in debt, and controlled a derivative book totalling
$1.25 trillion. Small movements in financial instruments turned
nickels into billions in profits. Today J.P. Morgan Chase has
$42 billion in equity and controls $30.4 trillion in derivatives,
a leverage factor of 725:1. However, leverage is a two-edged sword
that can quickly turn profits into losses and just as quickly
into bankruptcy. 1
Derivatives have become the atomic bombs of modern finance. When they explode, as they did with Orange County, LTCM and now Enron, they create a swathe of destruction across the financial markets. Because they involve a high degree of leverage, they can produce high returns when they go right and catastrophe when they go wrong. It is unfortunate that the degree of risk they involve isn't properly measured. The models are based on probability theory and measuring volatility. Those models don't measure leverage and balance sheet risk. As was the case with LTCM and Enron, that leverage proved fatal. This is one reason why the markets are so frequently surprised by the sudden disasters that unfold.
Investment Versus Speculation
Risk has become a conundrum for our modern financial markets. This is one of the main problems of investing today. The financial world no longer pays as much attention to leverage and business risk as it should. Investors watch the movement of price; while institutions remained focused on volatility. Price and volatility may tell you much about surface risk, but it tells you very little about the risk that lies underneath. The problem goes back to the issue of investment versus speculation. Nowadays, the term of "investor" is used loosely to apply to anybody and everybody who invests in the stock market. The term "investment" used to mean an asset that, after thorough analysis, promised safety of principal and an adequate return. An investor was a person who used analysis and reason and applied it to making investment decisions on assets that were held long-term. An investor treated an investment as a business. It was through the practice of treating investments as a business, that the application of investment principles was most intelligently applied. Contrast this definition of investment to today's practice of buying and selling shares of stock by inexperienced investors who do not even know what it is they are buying or selling. This distinction between investment and speculation in common stocks has disappeared from the financial landscape. Wall Street ads emphasize that investors stay the course and focus on the long-term. At the same time, other ads appear urging investors to trade. The subliminal message is to keep your money invested, but to constantly trade it.
Graham was right.
With the outlook for the economy and the financial
markets remaining uncertain, investors are in desperate need of
sound financial advice. Sadly, they will not find it on Wall Street
or in the financial media. Investors will only find it by returning
to sound investment principles that have stood the test of time. Benjamin
Graham's concept of "Margin of Safety" is as relevant
today as it was yesterday, especially given the amount of leverage
in the financial markets. Graham's "Margin of Safety"
became the central tenet of his investment philosophy. Graham
took the concept from the bond market and applied it to stocks.
Fixed income investors understand the importance of a company
earning enough income to meet its interest and principal payments.
The margin of safety for bond investors lies in a company's ability
to earn in excess of what is required to meet its debt obligations.
The greater the earnings, and the excess above required debt payments,
the greater the safety to bondholders. It is this surplus, above
what is required to meet interest obligations, that provides bond
investors a level of comfort if future corporate earnings decline.
Bond investors know the future will never be the same as the past. If the future was predictable, then the margin of safety demanded might be smaller. Therefore with a less predictable future, greater safety is demanded. That safety comes from knowing that a company can easily cover its debt expenses many times over. If a company has interest expense of $1 and has earnings of $10, then interest coverage is ten times interest expense, and provides the bond investor with a wide margin of safety. The lower the interest expense coverage, the lower the margin of safety of the bond investment. Since the future is never certain, the need for a higher safety margin to cover a possible future decline in net income is greater. To quote Graham, "...the function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future. If the margin is a large one, then it is enough to assume that the future earnings will not fall far below those of the past in order for an investor to feel sufficiently protected against the vicissitudes of time". 2
Graham's genius was that he could conceptualize the same principle and apply it to the evaluation of common stocks. The ideal situation would be a company that has no debt which would allow it to ride out a sudden change in its operating environment or a downturn in the economy. But Graham took this concept a bit further by applying it to company earnings and what an investor should pay for a stock. Graham equated the earning power of a corporation to that of an interest rate offered on a bond. For stock investors, the margin of safety would lie in an earnings yield that was considerably above the interest rate offered on a bond. This could be directly measured by looking at the earnings yield of a stock. The earnings yield is the reciprocal of the P/E ratio. It is found by dividing a company's P/E ratio by 1. For example a P/E ratio of 10 translates into an earnings yield of 10%. (Earnings yield = 1/x where x equals the P/E multiple on a stock.) Essentially what you are doing, by converting the P/E multiple of a stock to an earnings yield, is figuring out the percentage return on your investment. It is what you, as a stockholder, earn on your investment when you buy a stock at its prevailing price and P/E multiple.
For Graham, the greater the earnings yield or lower the P/E ratio, the greater the degree of safety an investor enjoyed. For Graham, the margin of safety was always dependent on the price paid for a stock. He felt that, armed with sufficient knowledge and experience, an investor could form sound conclusions from facts and then act on them. To Graham's way of thinking, "You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right. ...in the world of securities, courage becomes the supreme virtue after adequate knowledge and tested judgment are at hand". 3
Graham distrusted projections of growth simply because they were less measurable. Graham wasn't against growth stock investing provided that future growth projections were conservative and reasonable. The problem for Graham and for investors today is that these projections are less reliable. In today's world, too much emphasis is placed on projections and not enough on current values. The market has always had a tendency to take growth companies and place a higher value on them than was justified. The concept of growth multiples is self defeating. The higher the growth rate, the higher the P/E multiple. The market is always willing to pay a premium for companies that can consistently deliver high levels of earnings growth. The problem is simply one of valuation. Eventually growth companies mature or their base of revenues and earnings get so large that high growth rates are mathematically impossible. A good example is Dell Computer. In its formative days, Dell was able to consistently deliver 40-50 percent growth rates in sales and earnings. That was a much easier task to accomplish when its sales were less than $1 billion. It is a much harder task to accomplish when your sales are at $30 billion.
During the technology mania of the late 90's, companies like Dell were awarded higher valuations even though their rate of growth was decelerating. While Dell's sales growth slowed, its market multiples grew. As with many tech companies during the technology bubble, Wall Street growth projections proved to be unrealistic. The P/E multiples should have been a warning sign. They were simply ignored by new paradigm theories that seemed to justify even higher multiples. In the case of Dell beginning in 1998, the company's sales and earnings growth began to slow down at the same time its earning multiple began to expand. In 1998 Dell's P/E multiple nearly doubled and continued to expand until the technology bubble burst in March of 2000.
During the Internet frenzy between 1997 and 2000, many company P/E multiples rose to heights never seen before. It was not uncommon to see P/E multiples that ranged from 200 to over 2,000 all of which were justified by appealing growth stories. In the case of Internet companies, there were no earnings. So something else needed to be valued. Measurement of success was in clicks, eyeballs or stickiness. Viewing these recent events, it is safe to declare that sound investment principles were completely abandoned. They were replaced by a "New Era" mantra that was promulgated by Wall Street in partnership with the financial media. It remains that way today. As the graphs below indicate, the market is still overpriced by any measurable yardstick of value. Unlike previous recessions or bear markets, the stock market was never cleansed of its excesses. P/E multiples are higher today than they were last year. That is because earnings have fallen faster than stock prices, which have caused P/E multiples to go even higher.
With a P/E multiple over 41 for the S&P 500 and over 28 for the Dow, stocks can hardly be called a bargain. These P/E multiples equate to an earnings yield of 2.4% for the S&P 500 and 3.5% for the Dow. This is hardly commensurate with the risk of a recession and a downturn in earnings. Wall Street is recommending that investors continue to buy stocks regardless of risk. In their view, P/E multiples are high, but they will soon be rectified by even higher earnings. With bond yields over 5% and earnings yields less than half of that, investors are not allowing for a "Margin of Safety" in buying stocks at these levels. In the case of technology stocks, the situation is even more perilous. Most tech companies are losing money. Those that are making money are selling at P/E multiples as high as 72, 65, and 39 for companies such as Cisco, Intel, and Microsoft. Those high P/E multiples translate into an earnings yield of 1.4%, 1.5%, and 2.5% respectively. Once again, investors are choosing to ignore Graham's principle of "Margin of Safety". They do so at their own financial peril.
Back to Basics
Graham's central tenet of "Margin of Safety" has become even more important in today's investment markets where financial statements have become less reliable for the average investor as well as the pro. Income statements and balance sheets have become more opaque and are more difficult to decipher. In today's markets, earnings often depend on the words of an x-president, "It depends on your definition of what 'is' is." As I have elaborated in Earnings Game and in A Penny Less and a Penny More, earnings can mean many things. Yesterday was a perfect example. Yahoo reported pro-forma earnings of $16.7 million. The real numbers showed that the company actually lost $8.7 million. The two numbers are worlds apart. That is why the investor today needs to adhere to measurable investment principles. At a time when markets are overvalued, when the economic outlook is less certain, and when the country is at war, safety takes on new meaning.
We live in a time when the financial system is subject to perilous risks. Systemic risk is all around us in the economy, the financial markets, the international monetary system, and in war. We can no longer take what we see and hear at face value. We must learn to question it. Annual reports, and the numbers they contain, have become less reliable. The auditor's report is now subject to question and the financial numbers must be reconciled with the footnotes. We must learn to think of the investments we make as businesses or at least look at them in the same way that we shop. Examine the merchandise, compare the price, and be mindful of what you pay. Allow yourself a margin of safety, and learn to buy at a discount.
Many years ago when Jimmy Connors was making
his comeback in tennis a reporter asked him how he did it. He
replied by saying he went back to the basics and relearned the
fundamentals of tennis. It's time for investors to go back to
the fundamentals of investing. That means relearning the meaning
of Graham's "Margin of Safety". ~ JP
1
OCC 3Q Report on Derivatives
2 Graham,
Benjamin, The Intelligent Investor: The Classic Bestseller
on Value Investing, Harper Business, 1973,
P. 278.
3 Graham,
Benjamin, The Intelligent Investor: The Classic Bestseller
on Value Investing, Harper Business, 1973,
P. 287.
by James J. Puplava
January 18, 2002
Financial Sense (a Registered Trademark)
P. O. Box 1269
Poway, CA 92074 USA 858.486.3939
http://www.financialsense.com/
Please direct corrections and technical inquiries to webmaster@financialsense.com
Copyright © 2002 by James J. Puplava. All Rights Reserved.
Reprinted by USAGOLD with permission of Mr. Puplava. This article may NOT be reproduced without the expressed, written permission of the author. Selective quotations are permissible as long as the author, Jim Puplava, and his web site are acknowledged through hyperlink to: http://www.financialsense.com/
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