Return on Capital Employed (ROCE)
“Rule #1: Don’t lose money.”
“Rule #2: Don’t forget rule #1.”
– Warren Buffet
His most famous quote may sound simple, even obvious, but beneath those worlds lies the principle of investing: Capital Preservation. The aim isn’t just to grow wealth, but to preserve it while doing so.
In Buffett’s rulebook of investing, he has a “Plan A”.
Plan A: “Look for businesses with strong fundamentals, consistent cash flows, and the ability to repay debt comfortably.”
However macro markets are never predictable, and there is no guarantee on Plan A.
Margin of Safety
And there comes the crucial concept in “Plan B”: Margin of Safety.
Originally introduced by the book The Intelligent Investor by Ben Graham and so swiftfully applied by none other than his student Warren Buffet, the margin of safety is a risk-averse, cornerstone principle in value investing.
The margin of safety is the difference in value between the true value of a stock and the lower price at which you have bought it. Let’s say the intrinsic value of ABC Co.’s shares is $100 per share, and you buy it at a time in the market when the price was $80, you have created a margin of safety of 20%. Call it a reward for great timing and market research, or a buffer against volatility and errors in judgement, it is the money saved. And money saved is money earned.
Buffett himself says, “It’s not enough to buy a good company, you have to buy it at the right price. Quality isn’t enough if you overpay.” Though I don’t agree with him fully, but in this context I do.
Why Margin of Safety Matters
Investors don’t fancy risk, allowing the Margin of Safety to reduce the downside of investors’ decisions while providing upside potential.
But a low stock price doesn’t always mean it’s a bargain…it could be a trap !!
Sometimes, companies are cheaper for a reason: operational problems, unsustainable debt, declining relevance in their industry, up for a takeover. The aim is to find quality and sound businesses at discounted prices.
To approach carefully and effectively, investors need a structured guideline to identify whether a margin of safety even exists in a certain case.
The Intelligent Investor in practice
- Estimate intrinsic value:
To know whether a stock is undervalued, you must first understand its fair value based
on fundamentals, intrinsic value, excluding market hype. But how?
- Through tools and methods like:
- Discounted Cash Flow (DCF) analysis
- Price-to-earnings (P/E) ratio
- Return on Capital Employed (ROCE)
- Comparing industry multiples
- Free cash flow yield analysis
These are magical numbers, as I call it, which give extensive quantitative understandings of the inner workings of a business. They help evaluate a company’s financial health, growth prospects, and efficiency. A strong margin of safety exists when the market price is largely below the intrinsic value calculated.
- Company record and incentives:
Numbers alone can be misleading, there needs to be a sort of qualitative cushioning or justification for how those are the metrics. Why is the ROCE so high? Is there too little investment? What is the internal structure of the business like?
Look into:
- The company’s track record
- Debt levels and balance sheet strength
- Leadership incentives and governance
It is essential to understand the company’s future growth plans and how it operates
internally in terms of efficiency and fairness, to then infer on what their future prospects
look like. Does the business have a durable competitive advantage? Is it managed
efficiently? A high-quality company bought at a discount is a powerful combination.
- Market research and monitoring changes
Since we are dealing with equity, some external factors are deemed to impact company valuations.
- Regulatory changes
- Industry cycles
- Competitive threats
Will the price drop further, any opportunity costs? These are valid things to think about
when your aim is to maximize returns.
Reiterating the Legacy of the Founder: Benjamin Graham
Author, The Intelligent Investor
The Intelligent Investor is a sensational book that I highly recommend written by the father of investing, for anyone looking into investing. The clarity and guidance that Graham provides in the world of investing will truly elevate your understanding and build a passion for growing wealth.
To understand Margin of Safety, Graham covers 4 ideas (much more in his book) which are reiterated here to leave you with a genuine interest and will to benefit from such a natural market arbitrage.
1.Value investing :
This is the heart of the book. Buy undervalued stocks relative to their intrinsic value, and hold them until it reaches intrinsic value or higher.
2. Mr Market :
Personified as an emotional human-like existence, Mr Market offers daily mood swings in the form of volatile stock prices, by buying and selling shares everyday. The Intelligent investor listens but only acts when the deal makes sense, not based on emotion, benefitting from market upturns and shielded from downturns.
3. Margin of safety :
The wider the gap between price and value, the more room there is for error. This reduces risk and improves long-term outcomes.
4. Intrinsic value :
A value determined by a company’s earnings and growth potential. It is the value that deems whether a market price of a stock is providing a margin of safety or not. It is the anchor for all rational investing decisions
The margin of safety is not just a financial metric, it’s a mindset. It encourages discipline and patience in the face of uncertainty. By insisting on a margin between what something is worth and what you’re willing to pay, you shift the odds in your favor.
In a market driven by speculators, greedies and maniacs, these principles keep you grounded in logic, courage and long-term thinking irrespective of you being alone in the bargaining campaign.