My mother-in-law is known to my kids as Doodles. The name’s origin is a long story, but what’s important here is that she is extremely smart and a very capable businesswoman (she doesn’t go by “Doodles” professionally). Despite her business expertise, she is always asking me questions about the stock market that seem to miss the underlying philosophy behind long-term value investing.
In an effort to not seem like an evasive jerk, I will attempt to explain once and for all what I actually do.
(For the record, Doodles is just a proxy for every social acquaintance who has ever asked me a question about the stock market. If I am addressing a dumb statement, assume that it was an insane distant relative who inspired my commentary. If the question is nuanced and complicated, assume it was the work of Doodles.)
Last time we spoke, Doodles, I talked about competitive moats and how they help to define an investible universe of companies which are suitable for long-term investing (What 'Buy and Hold' Really Means
). Today I will talk about Margin of Safety, the most holy of doctrines in value investing. Benjamin Graham, the father of value investing, coined the term, and every value investor from Warren Buffett to Seth Klarman has mentioned it. In fact, Klarman used the term for the title of his out-of-print book, which now sells for around $1,000 for a used copy (or if you were the “value” sort, I suppose you could get it from a public library for less).
Value investors find the Margin of Safety to be so important because most of us are wired to be extremely paranoid about losing money. Buffett has his two famous rules for investing:
Rule No. 1: Never lose money.
Rule No. 2: Never forget Rule No. 1.
Not only is that cute, but it also seems to have been effective for The Oracle. Of course this doesn’t mean “never take any risk,” nor does it mean that you should expect your investments’ prices will only go up from the moment you buy them. It just means that you should make sure there is a serious cushion between the current market price and the cumulative future cash flows of the business (discounted to the present). You may get an analysis wrong occasionally and you will almost never buy at the bottom, but hopefully, large, permanent losses of capital will be rare.
It is tempting to think of the Margin of Safety as a machine-like certainty. “I built a spreadsheet with my projections for the business and it currently sells for 60% of that discounted forecast. Ergo: Margin of Safety.” You have predicted the future and now you need only sit back and wait for mere mortal investors to catch up with your clairvoyant brilliance.
The problem with this thinking is that you have framed the analysis as “How do I win?” You have likely created a narrative that draws a straight line from the current price to your estimated intrinsic value. You may be right on the eventual price direction and you might get some parts of the story to line up with your fortunetelling, but it is pretty rare for everything to work out exactly how you planned. Heck, half the time I make money on a stock it is for a reason completely different from my original thesis. But by focusing on a linear catalyst or story, you are setting yourself up to violate Buffett’s rules about not losing because you have not thought through lots of different scenarios. To defend against this vulnerability of thought, I flip the question around to frame it as “How do I not
lose?” I still have my base-case scenario for intrinsic value (How do I win?), but I also start from the current valuation and figure out a range of bare minimum events which will backstop the current price so that I don’t lose. Let’s look at an example.
Commercial Vehicle Group
(NASDAQ:CVGI) is the 400-pound gorilla in its niche as a supplier to commercial trucks and equipment manufacturers. It can provide pretty much every part that goes into a truck’s or construction vehicle’s cab. Its customers are the large Truck OEMs like Navistar
(PINK:DDAIF) and Volvo
and the Construction/Agricultural Vehicle OEMs like Caterpillar
(NYSE:CAT) and Deere
(NYSE:DE). The industry has been in a funk since an emissions regulatory change caused a glut of vehicles to hit the industry just as the economy was slowing in the late 2000s. The industry has never really recovered, as fleets have been wary of making a lot of firm plans in an uncertain economy.
CVGI’s management has navigated the economic waters pretty well, given the circumstances. It has avoided massive cash losses (though accounting losses were large) and been smart about acquisitions. Because of scale and operating expertise, they have a very strong competitive position.
Here are some of the ways I hope to not
lose with CVGI at these price levels:
1. Cycles: At some point the economy will stabilize enough that truck fleets will be more confident in purchasing plans. Increased economic activity means fleets will expand, which means more trucks. Additionally, today’s fleet is (by historical standards) “old,” meaning that operators will eventually look to replace old inefficient and unreliable trucks with newer efficient and reliable ones. The economic cycle and the replacement cycle are somewhat distinct, so whether it is one or both that happen, it would be a boost to CVGI’s results from current levels.
2.Taking market share: Because most trucks are customized products, it is important for a supplier to be able to deliver products exactly on time, lined up in production order, and with no defects. The supplier industry is very fragmented, with many of CVGI’s competitors operating in just a fraction of CVGI’s niches and sometimes with miniscule customer lists. As time marches on, OEMs look to simplify their list of suppliers. CVGI tends to grab some of this business each year (five or so percentage points of CVGI’s base revenue).
3. Acquisitions: Though acquisitions can be treacherous, CVGI uses M&A to buy into new niches where, because of its scale, it can quickly spread the new expertise to its broader client list. It also uses M&A to avoid starting from scratch gain in new geographies.
4. Developing-world growth: Developing markets like China, India, and Brazil are not only growing their underlying need for trucks, but are also rapidly increasing the content levels of their vehicles. CVGI is bringing the same competitive strengths it has in the US to similarly fragmented foreign supplier markets.
5. Investor mood: Investors have been skittish with CVGI for years. Every quarter’s earnings release is an exercise in breath-holding. As anything positive comes to pass, CVGI will eventually become less of a pariah to investors.
In total, management is targeting mid-cycle revenue of ~$1.6 billion in the next five years, which is around twice the current levels. In this scenario, EBITDA will likely approach $200 million versus a current Enterprise Value of ~$400 million (How do I win?). Even if only small pieces of its plan work, it should ensure that the stock price is (at the very least) not lower. A nice response to the question, How do I not
lose? And I know
you don’t want a loser for a son-in-law.