There are many great companies in the S&P 500 but, if you pay more for the stock than what the company is worth, you would be making a bad investment. And, in a market where many of the great companies have reached historically high valuations, the chances of making a bad investment increase substantially.
Is it possible for a great company to be a bad investment? The answer comes down to how much you pay for the investment. Benjamin Graham, the father of modern financial analysis, once said, “A great company is not a great investment if you pay too much for the stock.” There are many great companies in the S&P 500 but, if you pay more for the stock than what the company is worth, you would be making a bad investment. And, in a market where many of the great companies have reached historically high valuations, the chances of making a bad investment increase substantially.
The Margin of Safety Makes the Difference
In our last blog post, What’s Your Margin of Safety, we discussed how a “margin of safety” protects your investments against downside risk and increases your upside potential. The margin of safety around any stock is based on its price relative to the company’s value. Graham used a simple example to illustrate the value of the margin of safety. He posed that a stock that is fairly valued at $1 today could just as likely be valued at 50 cents as it could $1.50 in the future. In that circumstance, he wouldn’t buy the stock because he would be exposed to unnecessary risk.
Graham understood that, at fair market value, the valuation of that one dollar stock could be wrong. So he would wait until the stock is selling at a discount to its intrinsic value, which would limit his downside risk. While there’s no guarantee the stock price would increase from there, the discount provided him with the margin of safety that would minimize his downside risk.
When You Don’t Have a Crystal Ball
You can pay full value for the stock of a great company and, if nothing goes wrong, it can be a great investment. But, if something does go wrong, there’s no floor on the downside. The reason behind the margin of safety – and waiting patiently to buy the stock when it is well below the intrinsic worth of a company – is no one can predict market, economic or geopolitical events that could change the trajectory of a stock’s price. However, with an adequate margin of safety, there’s no reason to predict the future because you’ve already factored in a potential decline in value.
Unfortunately, too many investors look for great companies without concern for how much they are paying for them. They’re more concerned with what the company will do in the future. For example, you could be looking at a company that has grown earnings for 20 straight years and assume that it is likely to continue to do so. But, what’s the risk that could interrupt that pattern? We can’t know that so we must invest defensively.
Or, they look at a company like Tesla, which has never made a profit on a full-year basis. But they want to imagine what the company can earn five years into the future, without regard for the hundreds of possible risks that could derail the company’s efforts. Too many investors – and their advisors for that matter – would rather focus on the next big opportunity to make a quick profit, which changes the nature of investing to little more than speculation.
You Can’t Manage Performance, But You Can Manage Risks
A competent financial advisor would be the first person to tell you that it’s impossible to manage the performance of a company or its stock; but you can manage the risks, which is where the margin of safety comes in.
To find great companies that make great investments, investors must ensure they can realistically assess the value of such companies and whether an adequate margin of safety exists. That’s where the true value of an investment advisor reveals itself, which includes being able to confront their clients when that opportunity doesn’t exist. Patience and discipline are not natural tendencies for most people, which is why investors pay their advisors – to keep them from making costly mistakes.
