Nov 142012

Where does one look for an ample Margin of Safety?

There are tens of thousands of quoted stocks around the world. For stock selection to be a meaningful effort, the universe must be narrowed down to a manageable subset. Some investors restrict the choice by geography or sector. But proximity is an insufficient and increasingly irrelevant criterion, while sector specialization is a crude constraint, curtailing choice in exchange for a false sense of security. Others prefer to define certain characteristics: they look for “good companies”, “good business models”, “compounding machines”, “defensive moats”, and other similar concepts. This too, I think, is a distracting and ill-defined method. The goal of investing is not to find good companies but good prices. Restricting the choice for any other reason misses the point. This is not to say that any location, any business or any company will do. Further selection is always possible: it is sensible, for example, to avoid illiquid stocks, and to be wary of investing in more uncertain areas or in businesses that are difficult to comprehend. But the primary criterion must be price.

I look for companies where the price is highly likely to be wrong, i.e. where there is a wide gap between intrinsic value and market price: an ample Margin of Safety. The price can be wrong in relation to several dimensions, such as assets, equity, revenues, net income, operating earnings, cash flow, dividends. But this is not enough. There are hundreds, if not thousands, low – including negative – PE stocks. Likewise for the other measures. And, of course, it is not as simple as: the lower the ratio, the cheaper the stock. Very often, the price of a low PE stock is not wrong, but entirely justified.

Where the market price is more likely to be wrong is for companies that not only exhibit low valuation ratios, but also have a history of high growth and strong profitability.

Take a look at this company.

In the five years from 2006 to 2010, Operating Income grew at an annual compound rate of 92%. Average Operating Income Margin was about 10%. Net Income grew at 105% per year, and Shareholders’ Equity at 121%. With little or no Long-Term Debt, this meant an average Return on Invested Capital (ROIC) of 24%. In 2011, EBIT grew another 57% to 178.5, at a 14% margin. However, Net Income fell 58%, to 40.8, but mostly due a non-cash impairment of goodwill related to past acquisitions. As a result, ROIC fell to 5.9%, but Cash Flow ROIC was still a healthy 31%.

There is of course a lot more to it. But just based on these numbers, what would you say the value of this phenomenally growing and highly profitable company should be? Certainly, to be very conservative, we can say 1 billion. This would value the company at less than one times revenues, less than 6 times Operating Income and less than 5 times Operating Cash Flow. In fact, there were about 44 million shares outstanding at the end of 2010, so in the middle of 2011 the market valued Meyer Burger – this is the name of the company: it is a Swiss-based producer of systems for photovoltaics in the solar, semiconductor and optoelectronic industry – more than 40 Swiss Francs per share, or 1.8 billion.

What is the price today?

Less than 8 Swiss Francs, for a market capitalization of 380 million (there were 47 million shares outstanding at the end of 2011). The stock was down 50% in 2011 and is down again almost as much so far this year, close to the lows of 2009.

What happened? See it for yourself here and here. Basically, new orders have collapsed. This year’s revenues are likely to be between 600 and 800 million Swiss Francs and the company will make a loss (-47 million in the first half).

At a valuation of 1 billion, there is a 60% Margin of Safety.

Is this the demise of a terminally ill enterprise? Or, as the CEO said in the First Half 2012 Report:

Despite the persistent market uncertainties, we are convinced that the long-term prospects for photovoltaics remain positive. We continue to be confronted with unresolved environmental problems (e.g. global warming), as well as with environmental pollution and risks related to petroleum, coal or nuclear power, which make further initiatives for the use of renewable energies indispensable. New photovoltaic markets, for example in India, South America, above all Brazil, in Arabian countries, in Southeast Asia, as well as in Africa, especially South Africa, will ensure high growth in demand in the coming years and outperform the Western European markets that were the growth drivers in our industry in the past. A number of long-term government programmes and initiatives to promote renewable energies are also very positive and will lead to further growth in the industry. In addition, grid parity has already been reached in various important markets, also as a consequence of current low module and cell prices. The costs of solar electricity will continue to decline in the coming years due to new improvements in efficiency and technology. Based on these considerations, we are convinced that solar energy sources will cover, in the long run, a significant part of global energy requirements both efficiently and in an environmentally friendly manner.

 I am trying to make up my mind. But, to go back to search methods:

  1. This is a Swiss company. So what? What can be the point of leaving Swiss companies out of any search? By the way, 77% of Meyer Burger’s sales are to Asia.
  2. Which sector is Meyer Burger in? Industrial Machinery? Technology? Semiconductors? I don’t know and I don’t care. What I know is that this is a company that sells products and tries to make a profit. Am I an expert in photovoltaics? No. But I can make an informed judgment based on imperfect knowledge. This is what Bayes is all about. A Seth Klarman says:

Some investors insist on trying to obtain perfect knowledge about their impending investments, researching companies until they think they know everything there is to know about them. They study the industry and the competition, contact former employees, industry consultants, and analysts, and become personally acquainted with top management. They analyze financial statements for the past decade and stock price trends for even longer. This diligence is admirable, but it has two shortcomings. First, no matter how much research is performed, some information always remains elusive; investors have to learn to live with less than complete information. Second, even if an investor could know all the facts about an investment, he or she would not necessarily profit.
This is not to say that fundamental analysis is not useful. It certainly is. But information generally follows the well-known 80/20 rule: the first 80 percent of the available information is gathered in the first 20 percent of the time spent. The value of in-depth fundamental analysis is subject to diminishing marginal returns. (Margin of Safety, p. 156-157)

      3.  Does Meyer Burger have a “good business model”? Does it have a moat? Perhaps. It will be good to find out. But I would not have come across it if I searched for “good companies” (whatever that means).

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