The question that confronts me: are CAPM and margin of safety two sides of the same coin? Let's explore.
In chapter 20 of The Intelligent Investor Benjamin Graham wrote thus: Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, margin of safety. He propagated margin of safety as the central concept of investment, and noted that this concept renders an accurate estimate of the future unnecessary. While it is applicable to all securities, for a common stock, bought for investment under normal conditions, the margin of safety lies in an expected earning power considerably above the going rate for bonds. The risk of paying too much for a good quality stock is a real one, and overpaying for a low quality stock is much real. Therefore, margin of safety becomes necessary and evident when there is a favorable difference between the market price and the intrinsic value. This is very well written indeed, and there is no dispute there.
In chapter 20 of The Intelligent Investor Benjamin Graham wrote thus: Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, margin of safety. He propagated margin of safety as the central concept of investment, and noted that this concept renders an accurate estimate of the future unnecessary. While it is applicable to all securities, for a common stock, bought for investment under normal conditions, the margin of safety lies in an expected earning power considerably above the going rate for bonds. The risk of paying too much for a good quality stock is a real one, and overpaying for a low quality stock is much real. Therefore, margin of safety becomes necessary and evident when there is a favorable difference between the market price and the intrinsic value. This is very well written indeed, and there is no dispute there.
His number one disciple, Warren Buffett embraced it instantly and has been applying it in all of his investment decisions. He may have modified the concept a bit to include high quality businesses, consistently earning excess returns, managed by honest, ethical and capable managers. For him, such businesses inherently possess certain margin of safety, and when price paid is reasonable, the investment becomes more than ordinary. This too is a very sensible idea, and I don't have any arguments.
Both Buffett and his partner Charlie Munger have been very critical of the understanding of risk and business valuation by business schools. This is very true, and I too endorse their views.
The margin of safety concept can be extended to businesses having superior brands or unregulated franchise businesses. However, it is heavily dependent upon the price paid. The larger the gap between price and value, the larger the margin of safety, and the safer the investment.
If we understand that there is a fundamental difference between price (what we pay) and value (the intrinsic worth), it should be adequate. We can call it the margin of safety or the comfort level or simply the gap, or whatever else.
What bothers me, though, is the interpretation of their community, - oh, I have to use that word now - value investors. For them, anything that others do is worth some bashing.
Their favorite topic for attack is the concept of risk. As much as value investors like to talk about futility of risk and return models, they tend to do the same implicitly.
For business schools, academicians, and the majority of analysts, return sought is directly proportional to the risk assumed. The higher the risk, the higher the expected return. Their best proxy for risk is the volatility (measured by beta) in stock prices, which can be of any period: daily, weekly, monthly, quarterly or yearly. This is utter nonsense because short term fluctuations in prices have no bearing on long term investment returns.
This is again beautifully laid down by Graham: The rate of return sought should be dependent, rather, upon the intelligent effort the investor is willing and able to bring to bear on his task. For Buffett, is quite clear: If you buy a dollar bill for 60 cents, it is riskier than if you buy it for 40 cents, but the expectation of reward is greater in the latter case.
My experience has been that higher risk does not merit expectation of higher returns. In fact, it should be quite the opposite. In investing, one should look for low risk opportunities which have potential for higher returns. If there is no value in an investment, it is a speculation. I do not hold all those, who use higher risk higher return model and measure risk by short term volatility in prices, in the category of investors.
Risk should mean returns lower than alternative investment returns. It includes permanent loss of capital. It also includes, for instance, actual returns realized on a stock which are far lower than say, government (or any other AAA rated) bonds. The logic is simple: If we could get 8% on a government security which is (almost) riskfree in terms of nominal capital and has (almost) no default risk, why should we settle for a bond or a stock that yields lower than that?
However, the catch is that the return should be based on the actual realized return rather than daily, monthly, quarterly, or yearly (notional) returns. If we are not forced to sell our investment, any volatility during the period is only academic. Moreover, an investor does not sell based on short term fluctuations in prices; his rationale for sale is purely based on the gap between price and value, and alternative opportunities available. Therefore, if we chuck short term events, it becomes clear that risk lies in lower returns realized during the investment period.
The real risk actually lies in not able to retain the purchasing power of cash flows. If you are not able to do that it is not worth investing. Alas, no many realize that even AAA rated bonds erode in value due to inflation. Those government bonds may not even be riskfree in real terms.
Having laid down my thoughts on price and value, investment and speculation, and risk and reward, I would like to note how value investors and others use the discount rate to value stocks.
Buffett supposedly uses the same discount rate (usually the treasury bond rate) to value all businesses. However, Munger recently mentioned, again supposedly, that different businesses need different rates. We don't know what exactly they do for they have never come up with their valuation methodology, and this has led people to assume based on their own interpretation.
Value investors use a discount rate that is not based on beta and CAPM. They may use treasury bond rates, AAA bond rates, or some higher (implicitly due to risky cash flows) rates for valuing businesses. They like to say lower risk higher return, yet they are willing to increase the discount rate when cash flows are difficult to estimate. Then they like to apply a margin of safety depending upon how they feel about cash flows.
Now, the others, use a discount rate that is based on beta and CAPM. They like to use higher discount rate for risky cash flows, and lower discount rate for less risky cash flows. In fact, they use treasury rates for certain cash flows, which can only be in text books.
One can posit that there is not much difference between how value investors and others value a business. Let us consider an example of a business which has perpetual free cash flows of $120 m.
The value of that business for a value investor could be:
Value of the business is estimated to be $1,200 m. However, since the value investor is not sure of his valuation (but does not like to call cash flows risky), he applies a margin of safety of say, 20%, to arrive at a buy price of $960 m.
The value of that business for the other investor could be:
Since the other investor is not sure of his cash flows (and likes to call it risky), he uses a higher discount rate calculated based on beta and CAPM, and estimates the value of the business at $960 m, which is also his buy price.
We notice that both the value investor's and the other investor's buy price is the same at $960 m. While one has applied a margin of safety due to uncertainty of value, the other has used higher discount rate due to riskiness of cash flows. How wonderful it is that both values are the same.
Now, how the heck an investor like me is going to interpret it? We can also conclude that the value investor's buy price has an implied discount rate of 12.50%, and the other investor's buy price has an implied margin of safety of 20%.
I really don't care what people call it, margin of safety or risk-adjusted discount rate. I am neither a value investor nor a growth investor; I don't want any tag to my investing philosophy. I would like to believe that I am an investor and not a speculator. I try not to operate based on hope, greed, fear or envy. For me, there are certain fundamental philosophies on investing:
1) Value of a business is the present value of its cash flows over its life discounted at an appropriate rate.
2) The rate of return is not dependent upon the riskiness of cash flows.
3) Higher rate for higher risk is for schmucks.
4) The margin of safety has to be used in the context of the extent of gap between price and value.
5) You cannot use cash flows that are difficult to estimate (i.e. risky cash flows), and then apply a margin of safety. That is schmuck too.
6) There are three variables in valuing a business: cash flows, growth rate and discount rate.
7) The cash flows have to be as near certain as possible. If this can't be you have to let it pass.
8) The growth rate should be as reasonable as possible. On a perpetual basis, the growth rate has to be less than the economy's growth rate.
9) The discount rate should be based on an expectation of purchasing power and alternative opportunities available.
There are some value investors who try to be smarter, and use both higher discount rate and apply a margin of safety. I call them double whammies, and precisely schmucks.
I have another philosophy too: We cannot value a business at all because neither our estimates of cash flows are certain to occur nor the discount rate used is going to be appropriate. As a corollary, we can set a buy price based on our expected return, and play the equity game. I will keep that for another post.
Now back to the original question: are CAPM and margin of safety two sides of the same coin? I don't know. You tell me.
My experience has been that higher risk does not merit expectation of higher returns. In fact, it should be quite the opposite. In investing, one should look for low risk opportunities which have potential for higher returns. If there is no value in an investment, it is a speculation. I do not hold all those, who use higher risk higher return model and measure risk by short term volatility in prices, in the category of investors.
Risk should mean returns lower than alternative investment returns. It includes permanent loss of capital. It also includes, for instance, actual returns realized on a stock which are far lower than say, government (or any other AAA rated) bonds. The logic is simple: If we could get 8% on a government security which is (almost) riskfree in terms of nominal capital and has (almost) no default risk, why should we settle for a bond or a stock that yields lower than that?
However, the catch is that the return should be based on the actual realized return rather than daily, monthly, quarterly, or yearly (notional) returns. If we are not forced to sell our investment, any volatility during the period is only academic. Moreover, an investor does not sell based on short term fluctuations in prices; his rationale for sale is purely based on the gap between price and value, and alternative opportunities available. Therefore, if we chuck short term events, it becomes clear that risk lies in lower returns realized during the investment period.
The real risk actually lies in not able to retain the purchasing power of cash flows. If you are not able to do that it is not worth investing. Alas, no many realize that even AAA rated bonds erode in value due to inflation. Those government bonds may not even be riskfree in real terms.
Having laid down my thoughts on price and value, investment and speculation, and risk and reward, I would like to note how value investors and others use the discount rate to value stocks.
Buffett supposedly uses the same discount rate (usually the treasury bond rate) to value all businesses. However, Munger recently mentioned, again supposedly, that different businesses need different rates. We don't know what exactly they do for they have never come up with their valuation methodology, and this has led people to assume based on their own interpretation.
Value investors use a discount rate that is not based on beta and CAPM. They may use treasury bond rates, AAA bond rates, or some higher (implicitly due to risky cash flows) rates for valuing businesses. They like to say lower risk higher return, yet they are willing to increase the discount rate when cash flows are difficult to estimate. Then they like to apply a margin of safety depending upon how they feel about cash flows.
Now, the others, use a discount rate that is based on beta and CAPM. They like to use higher discount rate for risky cash flows, and lower discount rate for less risky cash flows. In fact, they use treasury rates for certain cash flows, which can only be in text books.
One can posit that there is not much difference between how value investors and others value a business. Let us consider an example of a business which has perpetual free cash flows of $120 m.
The value of that business for a value investor could be:
Value of the business is estimated to be $1,200 m. However, since the value investor is not sure of his valuation (but does not like to call cash flows risky), he applies a margin of safety of say, 20%, to arrive at a buy price of $960 m.
The value of that business for the other investor could be:
Since the other investor is not sure of his cash flows (and likes to call it risky), he uses a higher discount rate calculated based on beta and CAPM, and estimates the value of the business at $960 m, which is also his buy price.
We notice that both the value investor's and the other investor's buy price is the same at $960 m. While one has applied a margin of safety due to uncertainty of value, the other has used higher discount rate due to riskiness of cash flows. How wonderful it is that both values are the same.
Now, how the heck an investor like me is going to interpret it? We can also conclude that the value investor's buy price has an implied discount rate of 12.50%, and the other investor's buy price has an implied margin of safety of 20%.
I really don't care what people call it, margin of safety or risk-adjusted discount rate. I am neither a value investor nor a growth investor; I don't want any tag to my investing philosophy. I would like to believe that I am an investor and not a speculator. I try not to operate based on hope, greed, fear or envy. For me, there are certain fundamental philosophies on investing:
1) Value of a business is the present value of its cash flows over its life discounted at an appropriate rate.
2) The rate of return is not dependent upon the riskiness of cash flows.
3) Higher rate for higher risk is for schmucks.
4) The margin of safety has to be used in the context of the extent of gap between price and value.
5) You cannot use cash flows that are difficult to estimate (i.e. risky cash flows), and then apply a margin of safety. That is schmuck too.
6) There are three variables in valuing a business: cash flows, growth rate and discount rate.
7) The cash flows have to be as near certain as possible. If this can't be you have to let it pass.
8) The growth rate should be as reasonable as possible. On a perpetual basis, the growth rate has to be less than the economy's growth rate.
9) The discount rate should be based on an expectation of purchasing power and alternative opportunities available.
There are some value investors who try to be smarter, and use both higher discount rate and apply a margin of safety. I call them double whammies, and precisely schmucks.
I have another philosophy too: We cannot value a business at all because neither our estimates of cash flows are certain to occur nor the discount rate used is going to be appropriate. As a corollary, we can set a buy price based on our expected return, and play the equity game. I will keep that for another post.
Now back to the original question: are CAPM and margin of safety two sides of the same coin? I don't know. You tell me.
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