The Quality Margin of Safety

13 January 2021 | by Todd Wenning, CFA

We recently came across this fascinating chart by Nick Sleep and Qais Zakaria, who formerly ran the Nomad Investment Partnership. The chart shows how an investor – for decades! – could have paid much more than market price for Wal-Mart and still achieved 10% annualized returns through June 2009 when the Nomad post was published.

We’ve done a similar analysis on Costco and found that an investor could have paid 40 times trailing earnings for Costco at any point since 2002 and earned at least a 10% compound return through year-end 2020.

In the chart below, the blue line represents what your subsequent compound return would have been had you bought Costco at the market price between 2002 and 2015. The orange line shows what your return would have been had you paid 40 times earnings for Costco during that period.

Source: Costco, Bloomberg, Ensemble Capital

Both are illustrations of how the market can consistently underprice wonderful companies, a topic which we’ve discussed here and here.

One lesson investors should not take from these examples is that you can pay up for any company. The further you get from investing in an exceptional business, the more valuation should matter to your thesis.

While many investors look at historical valuation ranges as a cross check against their bottom up valuations, when you’re looking back at the performance of long-term outperformers, the historical ranges are, by definition, too low. You should have been willing to pay much more than the contemporary multiples suggested.

As the charts above show, a better method for analyzing long-term outperformers is to consider what you “could have” paid and still realized average market returns.

At Ensemble, we estimate a fair value for every company that we own. The distance between the market price and our fair value estimate is included in our formula for determining position size. Valuation matters a great deal to our process.

Value investing is built around the “margin of safety” concept – even if things don’t go as planned, you can still have a good outcome if you bought cheaply enough.

Similarly, if you have correctly assessed a business’s underlying quality – things like its moat, relevance, management team, culture, etc. – then you also have a “margin of safety,” even if it’s harder to quantify than it is with a valuation model. We might visualize the quality margin of safety as the spread between the two lines in the above charts.

Unlike the value definition of “margin of safety” where your biggest risk is not buying cheap enough, with quality “margin of safety” your biggest risk is not buying enough or selling too soon.

With hindsight, we can look at Wal-Mart and Costco in the above periods and say that valuation work wasn’t necessary. We should have gladly paid the market price and done nothing. But investing is a forward-looking exercise.

It should never be assumed that today’s great companies will be tomorrow’s great companies. In fact, we used to own Costco and sold in 2012. (We’ve since added back a small position in Costco.) At the time, we had concerns about Amazon Prime becoming the default “membership-based retailer” and diminishing the value of the Costco membership.

In 2012, we had legitimate concerns about Costco’s moat and relevance. Any valuation work we had done on Costco took a backseat to our worries about quality. In other words, our estimation of Costco’s quality margin of safety diminished.

With hindsight, we were right about Amazon’s Prime memberships, but wrong about its impact on Costco. In a different set of circumstances, it may have played out differently. We should always be prepared to change our minds about any business we own, especially when its quality is in question.

Our biggest mistake in selling Costco in 2012 was not fully appreciating its culture and the reasons why its customers are so passionate about their memberships (i.e. Costco gives frugal people permission to splurge). We didn’t set the bar high enough. Not only did Costco survive the Amazon challenge, but it’s thriving. Membership renewal rates are at record highs.

Source: Reuters/Duane Tanouye

If we’re going to be wrong about a company, we’d rather it be due to a misunderstanding of its underlying quality than a valuation issue. Valuation being quantifiable is much easier to rationalize and come to terms with than a qualitative mistake, but we can learn more from qualitative mistakes and become better investors.

By insisting on owning only what we consider to be exceptional businesses, we believe our investment outcomes will depend more on whether we were right about the business’s quality rather than if we were right about its valuation.

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

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