Is LKQ Corp a Buy, & More: Invest In Stocks With A Margin of Safety To Reduce Risk And Enhance Returns

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Of all of the many sound investing principles that legendary teacher and investor Ben Graham put forward, he believed that his concept of “margin of safety” was the most important of all.  This investment lesson was so deeply ingrained into the mind of Ben Graham’s most famous student, Warren Buffett, that he created his two most important rules of sound investing.  Rule number one: Never lose money.  Rule number two: Never forget rule number one. Clearly, both of these renowned sages understood the importance of minimizing risk, especially when investing in equities.  The following quote from Ben’s famous book The Intelligent Investor corroborates and summarizes my point:

“In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, This too will pass.”* Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY. This is the thread that runs through all the preceding discussion of investment policy—often explicitly, sometimes in a less direct fashion.”  Chapter 20: The Intelligent Investor.

Investors at all levels of skill and experience will intuitively accept and embrace the margin of safety concept.  However, not all investors will dutifully follow it, but few could argue against its validity.  Moreover, those that would reject the concept will often rationalize their not following of this simple, yet profoundly important rule based on another widely-held notion that in order to get higher returns, you must simultaneously be willing to take on more risk.

One of my primary objectives with writing this article is to turn this last notion on its head.  I intend to demonstrate that one of the most salient features of Ben Graham’s motto, MARGIN OF SAFETY, is that it not only reduces downside risk when investing in equities, but how it also simultaneously enhances future returns.  Lowering risk, while concurrently increasing return, is a fundamental tenet, and automatic benefit, of investing in a common stock when it provides the investor a large margin of safety.  Yes, investing in a stock when it offers a margin of safety undeniably lowers risk and presents the opportunity for enhanced long-term return.

In order to understand how this works, it’s implicit that we also understand exactly what a margin of safety is and means.  Simply stated, a common stock offers a margin of safety when it can be purchased at a valuation that is lower than its intrinsic value.  Moreover, the wider the gap between current value and intrinsic value, the greater will be the margin of safety.  Regarding investing in a stock when it offers a large margin of safety, some may find this next reality ironic. This also means that the safer the stock is, the greater the potential for higher future rewards it offers.  Achieving a higher return, while taking less risk, is nirvana for common stock investors.

At this point, some clarity is in order.  The margin of safety principle relates to investing in the same individual stock at different levels of valuation.  In other words, I am addressing the risk reward ratio of investing in a single or particular company, at different levels of valuation.  Consequently, it must be understood that the company possesses the same attributes of fundamental quality, and growth potential regardless of valuation.

 Consequently, the higher the valuation, the greater will be the risk, and the lower the return that investment in the company provides.  Conversely, at low valuations, the risk of owning the company is lower, but the potential future return higher.  Although this defies the principle that you must take higher risk in order to get a higher return, when investing in common stocks it represents an indisputable truth.

Margin of Safety: What It Is and How It Works

At this point, it is important to state that margin of safety is a value investor’s concept.  Moreover, it defies the conventional definition or concept of risk as defined by Modern Portfolio Theory (MPT).

Practitioners of MPT rely heavily on the concept of beta to define risk.  The following Warren Buffett quote on beta summarizes both of our views on beta:

“Value investors scorn the idea of beta because it implies that a stock that has fallen sharply in value is more risky than it was before it fell. A value investor would argue that a company represents a lower-risk investment after it falls in value.”

Since a picture is worth a thousand words, I will provide a few examples utilizing the F.A.S.T. Graphs™, Fundamentals Analyzer Software Tool to illustrate the value investor’s concept of margin of safety, and how it simultaneously reduces risk and enhances return.  The reader should further note, that what follows are simply offered as examples of how the margin of safety concept works.  Additionally, I will provide two examples of classic dividend growth stocks, and two examples of aggressive pure growth stocks to illustrate how this concept universally applies.

As an interesting sidebar, all of the following examples will illustrate what I believe to be a great irony of investing.  In reality, based on the entire historical precedent throughout all market history, the very best time to buy common stocks is when people dislike them the most.  And of course, I am referring to recessions which represent periods when people not only dislike stocks, they also flee them.  Once again I turn to Ben Graham’s The Intelligent Investor to provide insight into the fallacy behind this thinking.  The following is found in the footnotes of Chapter 20 on Pages 521 and 522:

“Graham is saying that there is no such thing as a good or bad stock; there are only cheap stocks and expensive stocks. Even the best company becomes a “sell” when its stock price goes too high, while the worst company is worth buying if its stock goes low enough.”

“Similarly, Wall Street’s analysts have always tended to call a stock a “strong buy” when its price is high, and to label it a “sell” after its price has fallen—the exact opposite of what Graham (and simple common sense) would dictate. As he does throughout the book, Graham is distinguishing speculation—or buying on the hope that a stock’s price will keep going up—from investing, or buying on the basis of what the underlying business is worth.”

Sample Dividend Growth Stocks

AFLAC Incorporated (NYSE:AFL)

My first example looks at what happened to AFLAC Incorporated (NYSE:AFL)’s stock price (the black line) as we entered the Great Recession of 2008-2009.  Notice how earnings, the orange line on the graph, held up much better than the stock price.  More plainly stated, the price fell far more than fundamentals justified that it should.  Therefore, once AFLAC Incorporated (NYSE:AFL)’s stock price fell below the orange earnings justified value line (intrinsic value) a clear margin of safety was created.  Moreover, the farther it fell, the safer it became while simultaneously the reward for investing in AFLAC Incorporated (NYSE:AFL) also was enhanced.

Additionally, notice that for all the years prior to that, including the recession of 2001, Aflac’s price had never fallen below its intrinsic value (the orange line).  And perhaps even more importantly, notice that AFLAC Incorporated (NYSE:AFL) raised their dividend every year (the pink line on the graph plots dividends).  Also, the reader should further realize that at Aflac’s low price of $10.83 in the spring of 2009, it provided the astute investor approximately a 10% current dividend yield.

Therefore, at exactly the same time that Aflac’s stock provided the highest margin of safety, it also provided the highest current yield of 10.34%, and the highest future capital gain potential than at any other time.  In other words, AFLAC Incorporated (NYSE:AFL) offered investors both its highest capital gain potential, and an extremely high current yield, at precisely the safest time you could have invested in it in modern history.

A deeper look into Aflac’s fundamentals provides additional evidence as to just how safe investing in Aflac was when its margin of safety was the highest.  The following FUN Graph (fundamental underlying numbers) plots Aflac’s cash per share (cashps) and more importantly as it relates to dividends, free cash flow per share (fcsflps). FUN Graphs calculates free cash flow after dividends have been paid.  Therefore, even during the throes of the Great Recession, Aflac’s finances were healthy and strong.


Although some could argue that since Aflac is in the Financial Sector, risk, or at least the perception of risk, would be higher than my rhetoric implies. 3M Co (NYSE:MMM) on the other hand is widely considered one of the bluest of all blue chips.  Therefore, as the following Earnings and Price Correlated graph depicts, the margin of safety principle is clearly evident.

Just like we saw with Aflac, 3M Co (NYSE:MMM) offered its highest yield and simultaneously its greatest capital gain potential at precisely the time when its margin of safety was strongest.  Stated more plainly, 3M Co (NYSE:MMM) offered investors its best returns when the risk with investing in it was at its lowest level.

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