Summary

• Buy and hold the stocks of quality companies with the history and continued likelihood of compounding total returns from capital gains and dividends.
• In this uncertain market, it is crucial to evaluate the downside risk and other measurements of the stock's margin of safety.
• Ultimately, search for a wide margin of safety for compounding returns through all market cycles.

Investing with a margin of safety is defined as the difference between the estimated intrinsic value of the stock and its current market price.

Powered by Ivy-League degrees and sophisticated software, Wall Street disseminates complex, assumptive financial models of seemingly precision earnings estimates and price targets, each market day.

But many of those projections ultimately play-out as no more intuitive than a crystal ball; otherwise, the investment elite would be as wealthy from portfolio performance as they are from fees and bonuses.

Disciplined, self-directed investors take a straightforward and more realistic approach to measuring intrinsic value by instead focusing on controllable quantitative areas that gauge enduring value from the compounding, dividend-paying common stocks of quality companies.

Predictably, the herd will ask, "At what specific price will the stock be trading next week, next year, and in the year 2028?" My answer:

I don't know. 

However, I do know that investing in common stocks to take advantage of the magic of compounding protected by a wide margin of safety is the best-case scenario for portfolio success over a lifetime, not just a single bull market.

The Magic of Compounding

Compounding is the financial process where we reinvest an asset’s earnings such as capital gains, interest payments, or dividend payouts back into the security with the intent of generating additional profits from the investment over time.

This astonishing mathematical inertia is the primary generator of real returns from equity and fixed income investing.

According to its investor relations site, Apple (AAPL) went public on December 12, 1980, at $22.00 per share. The stock has split four times since the IPO, splitting on a 2-for-1 basis on June 16, 1987, June 21, 2000, and February 28, 2005. The stock last split on a 7-for-1 basis on June 9, 2014.

On a split-adjusted basis, the IPO share price was a mere $0.39. The company paid quarterly dividends from April 1987 to October 1995, and from July 2012 to present.

Thus, a $5,000 investment during the initial public offering in December 1980, adjusted for stock splits, would be worth approximately $2.75 million today, plus dividends.

Apple is a captivating reminder of the power of compounded buy and hold investing for the self-directed investor to contemplate toward a commitment of total return from capital appreciation and dividend payments.

In 1919, one common share of Coca-Cola (KO) traded for approximately $40, coincidently about the same share price range as today. However, if held by the original purchaser, his or her estate would have enjoyed eleven varied stock splits yielding 9,216 shares from that lone original share, for a total current value of over $500,000 plus all those dividends! (Data source: The Coca-Cola Company investor site).

Thus, a $500 investment in KO in 1919 would be worth approximately $6.25 million today, net of dividends.

Coke’s story is another prime example of why self-directed common stock investors cherish the power of annual compounding from buying and holding the stocks of wonderful companies that possess enduring competitive advantages from in-demand products or services.

The ideal business is one that earns very high returns on capital, and that keeps using lots of capital at those high returns. That becomes a compounding machine. – Warren Buffett

Buffett’s wisdom and legendary investment results dictate the buying and holding of the common stocks of quality companies with the history and continued likelihood of compounding total returns from capital gains and dividends.

Protected By a Wide Margin of Safety

In general, a stock's margin of safety is calculated in one of two ways: the more common attempt of predicting the actual intrinsic value of the equity and then subtracting that estimate from the current price; and the more practical calculation of whether the stock represents a quality, enduring company currently trading at a reasonable price.

The former requires high intelligence and plenty of assumptions; the latter performs with thought, discipline, and patience in a review of the facts.

Margin of Safety in Practice

Some well-intentioned professional investors prefer to calculate the margin of safety with discounted future free cash flow projections and other future-focused and therefore, assumptive estimates of precision price targets within specific time frames.

These overly sophisticated margin of safety or intrinsic value estimates are what allegedly justify the high fee structure of Wall Street. However, be suspect of the projection nature of these formulas. If an investor has to start predicting future cash flows, interest rates, and capital expenditures, hasn’t he or she become more a speculator and less an investor?

Margin of Safety by Proxy

To the contrary, take a modest and frankly realistic approach to estimate intrinsic value. Thus, measure the margin of safety in a broader sense as opposed to Magic 8 Ball (MAT) specificity.

Try a margin of safety model that screens for reasonably priced stocks of companies with favorable earnings and free cash flow yields compared to the ten-year Treasury rate; adequate returns on equity, assets, and invested capital; attractive prices to sales, operating cash flow, and enterprise value to operating earnings; and controllable long- and short-term debt coverage.

In other words, assess the overall equity bond rates, earnings quality, management effectiveness, market valuation, and financial stability of the company.

I believe such an approach to calculating the margin of safety is a useful measure of a company's intrinsic worth based on current and trailing indices as opposed to assumptive future cash flows and other crystal ball projections. Ultimately, measure the margin of safety for longer-term value investing as opposed to shorter-term momentum trading.

Own common shares for the long-term benefit of partnering with a company that supports its customers with in-demand, useful products or services, rewards its employees with sustainable career opportunities, and compensates its shareholders with positive returns protected by world-class internal financial controls.

However, attempting to predict specific future prices or percentage gains and declines is a Wall Street game of chance that thoughtful, disciplined, and patient investors respectfully choose to avoid on Main Street.

Build Wealth or Income with Common Stock Investing

This over-extended bull market—including the unpredictable gyrations forced by the irrational sentiment of political leaders, traders, and speculators—is another reminder to stay invested in the stocks of companies with compounding capital gains and dividends protected by wide margins of safety.

When you patiently search for bargains to add to your portfolio only to find that new opportunities are temporarily nonexistent, you are better off just staying put.

And remember that the good ideas already sitting in your portfolio may be the best opportunities to invest dry powder as opposed to speculative or desperate new ideas.

Believing that the current business cycle is somehow different, investors are playing the fool's game by chasing the perceived fast money of trend following, momentum growth trading, cryptocurrency, waves on technical charts, and other speculative fads of the moment that put the herd's penchant for irrational behavior in full gear.

To the contrary, thoughtful, disciplined, and patient investors do not practice FOMO or the fear of missing out. Instead, he or she exercises the more practical FOLM or the fear of losing money. Because protecting your hard-earned principal should be priority number one.

In my view, the pursuit of alpha equates to a portfolio of dividend-paying common stocks of quality companies outperforming the S&P 500 benchmark over time, plus exceeding any other expectations I have placed on myself as a disciplined, long-view investor.

Although arguably the most challenging aspect of the investment paradigm, practicing patience is paramount to portfolio success as we wait for our investment theses to play out.

Confronted with a challenge to distill the secret of sound investment into three words, we venture the following motto, 'Margin of Safety' - Benjamin Graham, The Intelligent Investor.

Especially in this uncertain market, it is crucial to evaluate downside risk and other measurements of the stock's margin of safety in the near-view to take advantage of the magic of compounding of the stock’s capital gains and dividends over time.