The late Benjamin Graham was an economist and professional investor whose ideas have been highly influential. His many followers include the legendary investor Warren Buffett. Graham is credited, first and foremost, for pioneering and promoting the concept of value investing: buying stocks at bargain prices. In other words, value investing can be defined as finding and buying stocks whose market prices are lower than their intrinsic values, or what the price of the stock should be, as determined by the investor’s calculation.
Graham also coined the term “margin of safety,” which refers to the difference between the intrinsic value and market price of a stock. The idea is that if one purchased a stock at a price far below what he believes the intrinsic value of the stock is, even if he overestimated the worth of the stock, he will still turn a profit because he bought the stock at such a low valuation. On the other hand, if a stock was purchased with a small margin of safety, even a small overestimation of the stock’s intrinsic value could result in a loss. Thus, it is preferable to have as large a margin of safety as possible, and one should try to buy a stock when its market value is as far below its intrinsic values as possible.
The problem, of course, is that there is no objective measure of stocks’ intrinsic values. There are a large number of calculation methods available, and variables and intangible factors inject more guesswork into the valuation process. Thus, if the intrinsic value is difficult to determine, so too is the margin of safety.
Graham himself favored one simple calculation method. He favored taking the difference between a company’s earnings yield and the return on long-term riskless bonds. The difference, or spread, he called the margin of safety. The larger the margin, the more undervalued the stock is.
For example, if stock XYZ had an earnings yield (earnings per share divided by price) of 5 percent, and the 10-Year Treasury yield (typically used as the riskless benchmark) was 3 percent, then the margin of safety is 2 percent. What this means is that company earnings could be overestimated by as much as 2 percentage points and the stock would still be a likely better investment than the 10-Year Treasury note.
Thanks in part to ultra-low Treasury yields today, the margin of safety is one silver lining we can take away from what otherwise has been a sideways market and shaky economic backdrop; stocks are now in one of their most undervalued periods in recent years, when compared to Treasury notes.
As you can see from the graph, which charts the margin of safety for the S&P 500 (as measured by its earnings yield compared to the 10-Year Treasury yield) since 1990, the spread of 5.6 percent between earnings yield as of the end of the June quarter, was one of the widest in the last two decades. This means that, according to the calculation used, stocks are now at their most undervalued point in recent memory compared to Treasurys. This is a combination of investor pessimism in equities plus the unusually low Treasury yields.
What’s also interesting in the graph is that the spread has become larger over time, suggesting investor preference for stocks over bonds has waned. This is understandable because the 1990s was a strong period for the U.S. economy, with solid growth coupled with tepid inflation. Optimism was high. It was a time for buy, hold, and watch the investments grow. After the dot com bubble burst, 9/11, and the recession of the early 2000s, investors demanded better bargains before investing in equities. Then of course, we had the housing bubble burst, financial crisis and global recession in recent years, from which we have not fully recovered. Meanwhile, the European debt crisis, China’s slower growth, and an uncertain economic outlook in the U.S. remain major overhanging clouds today.
Current low valuations may be the saving grace to the weak market as it may encourage bargain hunting investors to step in and provide some lift to the market. Even if that doesn’t happen, with stock earnings yields now at significantly more attractive levels than Treasurys, stocks are offering investors higher reward for taking on risk than at most times in recent years. Bargains can be had if chosen carefully.