Margin of Safety
Our stock selection process is based on our version of Peter Lynch's Fair Value principles. Market capitalization is substituted for Enterprise Value and Invested Capital replaces net asset value. EV/IC ratio tells us the value or multiple accorded by investors to each dollar of capital invested in the company. We then compare this multiple to the company's Owner Earnings growth rate. Enterprise Value gives us the aggregate value of a company relative to a company's true profit after all costs including the cost of equity capital.
EV/IC valuation compared to Owner Earnings growth rate gives us a window to see how much investor expectations are built into the stock. We want to buy companies with strong Owner Earnings earning growth at reasonable valuations. As a general guideline, when the EV/IC ratio is too high, it leaves little room for error. It's best to pass on these types of investments.
Another stock selection method is intrinsic value. Intrinsic value is an estimate of the actual value of a company regardless of market value. It includes tangible and intangible factors, plus many variables of illiquid items which are difficult to properly value. Intrinsic value is a more subjective process as there are many different growth and interest rate assumptions made in the calculation of intrinsic value. Either way, the key to any valuation method is to identify value-added results for the shareholders.
The Margin of Safety Principle, popularized by Ben Graham, is the cornerstone of our investing process. Market expectations (EV/IC) are used rather than market price as a point of comparison to calculate our margin of safety. The key to our process is the fact that we do not make projections of any kind. No earnings forecasts, no sales forecasts, no interest rate forecasts, no growth forecasts, and no future projections. We are looking for the best and most profitable (Owner Earnings) companies in today's marketplace.