Margin of safety: how we account for being wrong

None of us can predict the future. A pandemic, the interest rate shock of 2022, or a completely normal economic downturn can quickly change conditions. Therefore, scepticism towards both our own and others' forecasts is crucial.

At Amos Value, the margin of safety is our most important protection against uncertainty. It means we buy when the price is well below what we estimate the company to be worth. We prefer a discount of at least 20%, but this is a benchmark. When few companies offer such a large discount, we choose the companies that provide the highest margin of safety relative to the risk. Regardless of the level, the margin of safety requires us to first value the company based on its history and conservative, reasonable assumptions about the future. Together with the dividend, the discount gives us belt and braces: the price is one safeguard and the dividend is the other.

A Calculation Example

Take the fictional service company Sunbeam & Cloud Ltd, which monitors solar panel installations for businesses. Growth is stable, and margins are improving slightly due to economies of scale. However, the company operates in an industry that the market is currently nervous about, as AI could make it easier for customers to monitor their own installations, and competition in renewables is intensifying. We believe the company creates value for customers and deserves a multiple of 15 times earnings (P/E ratio, i.e., the share price relative to earnings per share) thanks to reasonably rising revenue and earnings per share over the past ten years.

With earnings per share of SEK 10 and a multiple of 15, our fair value, i.e., what we estimate the share to be worth, is SEK 150. However, the share price is only SEK 120. The starting position therefore looks like this:

• Earnings per share: SEK 10
• Our multiple: 15 times earnings → fair value SEK 150
• Share price: SEK 120
• Margin of safety: SEK 30, i.e., a 20% discount, in line with our benchmark

We look at three potential outcomes.

1. We are wrong.The company performs slightly worse than we expected, and the market becomes more pessimistic.

• Profit stagnates at SEK 10 per share for two years
• The market values it at 11 times earnings → the share is worth SEK 110
• Dividend: SEK 5 per year (50% of profit) for two years = SEK 10
• Total: 110 + 10 = SEK 120, exactly what we paid

The return is zero, but we lose nothing. We were wrong and still managed: belt and braces in practice.

2. We are right.Profit grows as we expect, and the market shares our view.

• Profit rises 7% to SEK 10.70 next year
• The market values it at 15 times earnings → the share is worth SEK 160.50, an increase of almost 34% from SEK 120
• Dividend: SEK 5.35 (50% of profit)
• Total return after one year: just over 38%

3. Something in between.The company grows, but the market continues to value it low.

• Profit grows five to six percent per year for three years, to approximately SEK 11.60
• The market values it at 12 times earnings → the share is worth approximately SEK 140
• Dividends (half of profit): 5.25 + 5.50 + 5.80 = just over SEK 16
• Total return: approximately 9% per year

This is a reasonable return, even though the market continues to value the company low.

The example is fictional and neither a forecast nor a promise of future returns. It illustrates how the principle works.

Why doesn't everyone do this?

Some concrete reasons:

• It's time-consuming: Establishing your own fair value requires us to read and assess both income statements and balance sheets, and make a (reasonable) forecast about the future.
• We miss the quick parties: We virtually always pass on the year's hottest momentum stocks, which can make your neighbour rich. It requires discipline not to jump on the next trend.
• We risk missing the biggest long-term winners: Some argue that the best companies "were never cheap enough." We don't believe that's true, as most quality companies become attractive from time to time.
• We are in the freezer: When we buy unloved assets, we often have to wait a long time while the market is uninterested. Sometimes a whole year passes without the stock moving. It can be a lonely and barren time before the market hopefully agrees.

Sitting on "tired stocks" is the price of a value-based strategy. In return, we prefer to calculate rather than guess. We refuse to be dependent on the next buyer's optimism. We must be able to justify the company's value independently, and we are prepared to wait a long time, both when buying and when selling. We sell when the price has reached our fair value or when our assessment of the company has changed.