Margin of Safety

Small-cap sleuth James Boric makes the case for investing in one of 26 undervalued companies currently falling within the parameters of Graham’s ‘Margin of Safety’ rule. A sound strategy that could work for the conservative investor…even during this speculative rally.

The year was 1947.

President Harry Truman was in office. Jackie Robinson, the first African-American baseball player in the major leagues, debuted with the Brooklyn Dodgers. The Academy Award for best actor went to Ronald Coleman for his part in "A Double Life."

And Benjamin Graham made the single best investment of the 20th century.

In a move slated for the investment hall of fame, Graham bought 50% of a small company called Government Employees Insurance Co. (now GEICO) for $720,000. That was a lot of money in 1947. The average salary was $3,120 a year. Minimum wage was 40 cents an hour. And you could buy a new car for about $1,400. But Graham knew spending $720,000 for a 50% stake in GEICO was an absolute bargain.

Founded in 1934 by Leo Goodwin, GEICO sold deeply discounted car insurance via direct mail to federal employees and noncommissioned officers with good driving records. It was the first discount insurance company of its kind in the United States.

GEICO: A Solid Business Model, and More

By selling the insurance directly through the mail, GEICO was able to cut out the commissioned insurance agents. That was huge. By avoiding a large payroll, Goodwin kept his overhead costs low, his profit margins high and the competition at bay. No one else could offer comparable service for such low prices. The business model was solid. And Graham knew it.

But there was another reason Graham liked GEICO so much in 1947.

At the time of the purchase, GEICO’s assets alone were worth $3.3 million. If you divided them in half (to represent Graham’s cut of the company), he was buying $1.65 million of assets for $720,000 – 56% off the real price. Not a bad deal. Even if the stock price fell, Graham could sell the company’s assets and make a profit. This investment had what Graham called a "margin of safety" built into it.

In other words, if GEICO only grew to be valued at 1 times assets, Graham could cash out for a 56% profit – his $720,000 would be worth $1.1 million. And his downside risk was minimal.

GEICO had long-term profit potential growth. It was well- managed. And the company had a viable market for its services. It was unlikely to go out of business – which meant the chances of losing money on this deal were small. It was the perfect kind of investment for Graham.

As it turned out, Graham was right about GEICO. He did make money on the deal. But instead of turning his $720,000 into $1.1 million, he held on until his investment was worth a cool $1 billion. That’s billion – with a "B."

GEICO: No Fluke

And GEICO was no fluke investment.

Using the same margin of safety rule, Warren Buffett and John Templeton (both students under Graham) grew their multibillion-dollar empires from the ground up – copying Graham’s bargain-hunting approach. Buffett bought shares of Coca-Cola, American Express, Freddie Mac, Gillette, The Washington Post, GEICO and others – all for deep discounts to their real value. A $10,000 investment in Buffett’s Berkshire Hathaway in 1965 was worth $51 million in 1999.

Templeton, taking a slightly different approach, bought undervalued stocks in emerging markets like Japan (when the total market cap of all Japanese stocks was less than IBM’s), India, Russia, Argentina and Peru. Although the return in Templeton’s flagship fund, Templeton Growth, wasn’t as high as Buffett’s Berkshire Hathaway stock, it was still quite considerable. A $10,000 investment in 1965 was worth $5.5 million in 1999.

Graham, Buffett and Templeton were all successful because they refused to pay market value for a stock. And that meant they ignored the herd when it came to the hot stock tip du jour. Instead, they bought stock in companies no one else wanted – when a company was badly beaten down by the market, overlooked by Wall Street or simply under- researched.

But that was in the good old days when Coca-Cola and Gillette were penny stocks. Let’s be realistic – you and I will probably never find a stock with that kind of profit potential. Right?

Wrong. You can find the next GEICO, Coca-Cola and Gillette. But you have to be willing to look places other aren’t: the small-cap stock market.

GEICO: 26 out of 9,000

Of the nearly 9,000 stocks trading on an exchange (major or otherwise), only 26 are worth investing in if you use a modified version of Graham’s margin of safety rule. Not surprisingly, all but two are small-cap stocks with market caps under $1.5 billion. And all 26 trade for $20 or less and have the following similarities:

* They trade for less than 1 times book value and less than 1 times sales. * They are growing their sales and net income quarter-over- quarter and year-over-year. * Their total assets exceed their market-caps. * They trade for under 20 times earnings.

Will any of these stocks be the next GEICO? Who knows? If the worst they do is simply trade at their market values, anyone who invests in them will make money. Regardless of the state of the U.S. or global economy.

And it is possible one or two could take off and not stop for the next 20 years. Imagine if you happened to own that stock. Fifty years from now, some young contributor to The Daily Reckoning may start off his article like this…

"The year was 2003. President George W. Bush was in office. Lance Armstrong won the Tour de France for the fifth straight time. The Academy Award for best actor went to Adrien Brody for his role in ‘The Pianist.’ And (insert your name here) made the best investment of the 21st century."

You never know…


James Boric,
for The Daily Reckoning

November 25, 2003

P.S. Curious what the 26 stocks are that meet my "margin of safety" criteria? Please understand, I am in no way recommending these stocks. They simply fit the criteria I showed you above.

James Boric is the editor of the small-cap advisory letter Penny Stock Fortunes, where he looks for great companies at penny-stock prices. James also writes a weekly e-mail called the CXS Alert.

Huge current account deficits are nothing to worry about, says Alan Greenspan.

He might have saved his breath. For no one in America was worried, anyway. Trade and current account deficits have been rising for many years. People have begun to believe they go in no other direction. It is as if an economist had put his hand into a jar 15 times in a row and pulled out a red candy every time. "They are all sweets!" the scientist proclaims. Taking the last few years as data points, a dim economist finds nothing to contradict the hypothesis: current account deficits are no problem.

Investors, even dimmer, bet on more red candies. They bid stocks up to levels they have seen only 4 times in the entire 20th century – in 1929, 1972, 1987, and 2000. Only in 2000 – in terms of peak earnings – were they more expensive than they are now. And never did they escape a major adjustment downward.

"During the past year or so," Greenspan pointed out, looking on the bright side, "the financing of our external deficit was assisted by large accumulations of dollars by foreign central banks."

What a marvelous world, we keep noticing. We spend more than we earn. And then nice folks we’ve never met lend us back the money so we can spend some more. And if things get a little tight…our own financial authorities knock down interest rates to make it a little easier for us to keep spending.

Now, it is true that a current account deficit in itself is not a bad thing. Fast-growing economies – like start-up businesses – often run current account deficits; they need to import capital to build new factories and infrastructure. But the investments made by foreigners have to be productive ones.

America’s current account deficit is another variety. When you see construction in the U.S., it is almost always either residential or retail; rarely do you see new production facilities of any sort being built.

When foreigners fund America’s deficits, they do not contribute to additional U.S. production, jobs, and profits. Instead, the current account deficit does little more than allow Americans to continue spending more than they can afford – which has the effect of stimulating jobs, production and profits in the foreigners’ home economies, not in America.

Seventy percent of the U.S. economy is consumer spending. When Greenspan says the economy is ‘recovering,’ does it mean Americans are getting richer? Does it mean that the economy is healthier? Alas, what it really means is that spending has resumed…and that consumers are ruining themselves at a faster rate.

But watch out. The whole thing is a charade on both sides of the transaction. Americans spend money…thinking they are getting richer. Foreigners lend, thinking they will get it back. We don’t exactly know how this will end. But we are fairly sure the final act will be accompanied by tears and regrets.

"Something troubling has happened in the past few months," warns yesterday’s Financial Times. "Despite the falling dollar, which should make U.S. assets more attractive, there has been a noticeable acceleration in the pace at which foreign investors are selling U.S. bonds.

"According to the Treasury’s international capital system report for September, net inflows into U.S. markets fell to $4.2bn in September, the lowest since September 1998, when the near-collapse of the Long Term Capital Management hedge fund sparked a brief panic. The drop since May has been steep – from $110.4bn then, to $90.6bn in June, to $73.4bn in July, to $49.9bn in August."

At some point, American consumers are going to reach into the jar and pull out a bitter pill. Maybe soon. Maybe late. But sooner or later.

Over to Eric Fry, with the latest happy news from Wall Street:


Eric Fry, writing from New York…

– The Dow Jones Industrial Average raced into Thanksgiving week with a swift 119-point rally to 9,748, and the Nasdaq Composite advanced 2.8% to 1,947. The dollar drifted behind the sprinting stock market to gain nearly 1%, ending the New York trading session at $1.17 per euro.

– The twin rallies in stocks and the dollar buffeted the gold price, as waning demand for the safe-haven metal knocked $4.50 off of its price to $392.00 per euro. Bond prices also slipped, sending the yield on the 10-year Treasury to 4.23% from 4.15% on Friday.

– Safe-havens like gold and Treasury bonds are not so safe when the stock market is soaring. On the other hand, stocks can be dangerous things to own when investors are shunning safe havens. Excessive investor optimism often signals the beginning of major market sell-offs.

– The UBS Index of Investor Optimism surged 24 points in November to a 20-month high of 93 in November. According to the survey, a joint effort of UBS and the Gallup Organization, 60% of those surveyed consider the economy to be in a sustained expansion or recovery, up from 48% last month.

– Surging investor optimism – as all self-respecting contrarians are well aware – is an ominous sign for the stock market. Investors tend to become extremely hopeful and confident before steep market declines…and become extremely pessimistic before market rallies. Which brings to mind a related phenomenon, variously known as the "Pink Slip Indicator" or the "Sell Side Indicator."

– Here’s how it works: major Wall Street firms fire their bearish strategists immediately before major sell-offs begin, and fire their bullish strategists immediately before major rallies begin. According to this indicator, the stock market may be approaching the end of its year- long rally…The Pink Slip Indicator is flashing yellow.

– "Amid a rising tide of complaints," Reuters notes, "Merrill Lynch & Co.’s chief U.S. strategist, Richard Bernstein, is seeking to defend his bearish view of the stock market from investors who believe he is hopelessly wrong…Bolstering critics’ argument that Bernstein is off the mark is a 17.5 percent rise in the Standard & Poor’s 500 Index so far this year. The benchmark index closed at 1,033 on Thursday – significantly above Bernstein’s year- end target of 880."

– Merrill has not fired Bernstein…yet. But we are holding a vigil – and are readying our sell orders – for the day that Merrill replaces him with a strategist that voices a staunchly bullish outlook.

– Poor Merrill Lynch…the white-shoe firm just can’t seem to get it right. Back in the late 1990s, strategists like Abby Joseph Cohen and Joseph Battapaglia were making daily headlines with their incessantly bullish forecasts. Abby Cohen became a minor celebrity and brought accolades, fame and fortune to her employer, Goldman Sachs. Meanwhile, Merrill Lynch employed the habitually cautious Charles Clough as its chief strategist.

– While Abby and the other bullish seers were cheering from the sidelines, Clough urged restraint. Eventually, the top- brass at Merrill could no longer stand the humiliation of endorsing Clough’s bearish posture during the greatest bull market of the 20th century…Early in 2000, Merrill urged Mr. Clough to "pursue other interests."

– "Just before the bubble popped in 2000," Bull & Bear Investor recalls, "several Wall Street brokerage houses fired their most bearish strategists and economists…Chuck Clough was shown the door at Merrill Lynch. His doom and gloomster colleagues who suffered the same fate included J.P. Morgan’s chief strategist Douglas Cliggott, Salomon Brothers’ market strategist David Shulman and Oppenheimer’s renowned chief strategist Michael Metz. With the benefit of hindsight, all were fired for being correctly bearish."

– Merrill replaced Clough with uber-bull Christine Callies. The new chief investment strategist tried to make up for lost time by urging Merrill Lynch clients to buy stocks aggressively throughout 2001, even as the stock market was collapsing.

– Merrill was twice chagrined. The firm fired Callies in December of 2001, replacing her with the bearish Bernstein. Callies was the first of several high profile bulls to receive pink slips as the stock market headed toward its bear market lows of October 2002. "During the go-go years," CNN/Money observed one year ago, "nobody pounded the table quite as hard as Lehman Brothers’ Jeff Applegate and Credit Suisse First Boston’s Tom Galvin. Both had replaced bearish predecessors and both became progressively more bullish as the rally wore on. When the market hit a top in March 2000, they were each recommending that clients keep a whopping 80 percent of their portfolios in stocks."

– Alas, Applegate and Galvin both drew pink slips in the fall of 2002, just as the stock market was embarking on a massive, new bull market rally.

– Today, investors are very optimistic and bearish strategists are fighting off angry mobs…Hmmmm…maybe it’s time to hold a mirror beneath the nostrils of this bull market.


Bill Bonner back in Paris:

*** Poor Richard Bernstein. Merrill is out to get him, Eric notes above. He’s bearish on stocks; they want him bullish. He’s cautious; they want him to be reckless.

"It’s hard to find risk aversion in the marketplace right now," writes Bernstein. "We see considerably more speculation as the market goes up." The longer a trend remains in place, the less people imagine that it will ever change. Thus, the riskier the marketplace becomes, the less risk investors perceive.

As we pointed out last week, we don’t know which hoss will win dis race…but we’ll take the long odds on the nag named "Lazy Bear." He may or may not win, but if he does, he’ll pay off big. The downside risk is mis-priced.

*** Gold backed off yesterday. Conspiracy theorists believe that somebody is trying to hold the price of gold below $400. Well, more power to them. Let’s hope they knock the price back down to $370. We’ll buy more!

It now takes 25 ounces of gold to buy the 30 Dow stocks. A quarter century ago, an ounce of gold was about the same price it is today. But the Dow was much cheaper – so cheap that you could have bought the whole thing for only a little more than a single ounce of gold.

During those 25 years was the biggest explosion of dollar- based paper wealth in all history. Yet, the price of gold went nowhere. We doubt that it is destined to go nowhere forever. On the other hand, the Dow rose 25 fold against gold. Likewise, we doubt that it is destined to go somewhere extraordinary forever.

A couple of years ago, and in our book, we announced the Trade of the Decade. "Buy gold, sell stocks," we said. So far, gold has risen nicely. Stocks have fallen. But we suspect these trends have much, much farther to go before they finally reach their end. We’ll stick with the ‘Trade of the Decade’ a bit longer.

*** "Poor Edward," said Sylvie yesterday. Sylvie comes to the office from time to time to try to correct your editor’s French. She struggles in vain against lapses in the subjunctive mood and breaches in subject-verb agreements. But she offers some gallic philosophy along with the grammar:

"Yes, I know the mothers in the 16th arrondissement (a very bourgeois section of Paris) are like that…but it is a shame. They push the children to get into good schools. And then, because not all children are cut out for top schools, the poor children fail. So they put them in the next best school. Well, they don’t do well there either, because they’re just not well matched to the rigorous academic environment. So the kid fails again. And so the parents ratchet down, school by school, failure by failure, until they finally end up at a level where he can succeed. But by that time, the kid’s confidence is destroyed and all he can do is get a job in government…and feel like a failure all his life."

*** "Edward," we said to the boy last night, after his tutor had left at 6PM…and after his back-up checker-upper had left at 8:30PM …and after we had read a few pages of the Call of the Wild. Edward has been quiet for the last few days. We were worried.

"You know…school isn’t everything," we began.

"I know…"

"It’s not even the most important thing…"

"I know…"

"The important thing is just to do your best…and make sure you are doing the right thing…I mean, you know you’re not supposed to take B-B guns to school, for example…"

"Uh huh…"

"You just do your best…and don’t worry, right?"


"And if you do your best and don’t worry, I’ll be very proud of you…"

"Uh huh…"

"Goodnight, Edward."

"Goodnight, Dad."

The Daily Reckoning