Margin of safety and applicable measurements
After re-reading Been Graham's thoughts on margin of safety, I naturally wanted to look at today's market. He mentions that one measure of that margin is a company's earnings yield over it's debt payment (ie, a 9% yield vs 4% rate would be comfortable).
Would it be acceptable to use the CAPE multiple and inverse it to get the earnings yield and then compare that to 10 year corporate bond rates? The CAPE currently has a yield of about 3.5% while the 10 year corporate bond yield is roughly 4.3% (according to St Louis Fed). This results in a negative margin of safety.
Are these numbers acceptable to use? Should I not use the CAPE yield and instead use the current S&P yield (currently a little over 5%)?
What metrics do you use to measure a margin of safety in your investments or in the market as a whole?
Thanks
I learned nearly everything I currently know from the value style of investing, and I certainly think it works long term, but graham's "cigar butt" strategy doesn't have a lot of staying power in my opinion. I think there are structural reasons for this - access to info, decline in number of publicly traded names, emphasis on asset-light businesses like tech, and so on. yes, his returns are compelling, but don't forget a lot of his alpha came from having an extreme overweight in GEICO (just like phil fisher's came from an extreme OW in motorola).
in my opinion, a hybrid approach is best. make sure you use reasonable assumptions for growth, ensure the company can self fund (by and large, you don't need $0 debt), and stress test your scenarios.
also, CAPE is a notoriously horrible short term metric, it's more indicative of what you can expect to get from stocks over a long time period (which, after a nearly 10 year bull run, I think lower than avg returns is reasonable)
finally, I define margin of safety as insurance against you being wrong. what if the company missteps? does it have to deal with an earnings slowdown AND tap the credit markets or can it self fund? does it have a dividend payment that buys you time? does it have assets it can sell off if times are really tough? does it have a diverse base of customers? things like that. it's not as simple as the ERP (which is a terrible forecasting metric, btw), but it's also not as complex as you might think. I also think diversification, having cash on the sidelines, and so on can give you a margin of safety from a portfolio standpoint
Thanks for the comments. I agree that the cigar butt approach does not work for multiple reasons. However, is the shiller PE ratio (or inverse of it for yield) not useful when comparing that yield to 10 year corporate bond yields? I feel like looking at that spread would not be a waste of time. I remember Howard Marks saying that tightening credit spreads (I know I'm talking about an equity to debt spread) can be seen as indication of a willingness to bear greater incremental risk for similar returns. So I view this as accepting a lower return from stocks than bonds going forward even though stocks are historically more risky. Do you view this as an incorrect way of looking at things?
I think the shiller PE is very useful in terms of setting your expectations for return, and potentially for asset allocation, but if you use it as a timing mechanism for when to buy a stock/fund, it's no bueno.
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