Many market participants see themselves as value investors, striving to buy at a discount and sell at a premium to value.

Most understand the concept of margin of safety (MoS), first applied to investment affairs by Benjamin Graham. They see it as a one dimensional concept: the difference between value and price. The larger that margin, the safer the investment opportunity. And also the more compelling, for a given potential reward.

Some understand the three sources of genuine value: i) asset value, ii) earnings power value (EPV), and iii) earnings growth at returns above cost of capital.

But only a few bring the reasoning to the logical conclusion that there are two dimensions to the margin of safety: size and certainty.

Today, we are sharing with you the IW Margin of Safety Box (IW Box for short), a diagrammatic framework that has helped us enormously over the years in our investment and capital allocation decisions.

The IW Box puts together the two dimensions of the margin of safety: size and certainty. The further to the top (larger MoS) and right (more certain MoS), the safer the investment opportunity. And for a given potential reward, the more compelling. Cells at and above the diagonal represent adequate margins of safety. Cells below the diagonal, insufficient margins to open new long positions.

Evolution of value investing

In his investment decisions, Benjamin Graham confined the source of value to the net value of tangible assets, ideally current assets net of all liabilities (net net working capital). He viewed the value of intangibles, earnings power and growth as too uncertain to meaningfully contribute to value, and by extension, margin of safety.

Within the IW Box framework, he limited his investments to the rightmost column, in which the MoS, entirely substantiated by net assets, can be estimated with high certainty. The more tangible and current the assets, the more to the right within that column. And the larger the price discount relative to net asset value, the higher up along the column.

Even today, some investors refuse to pay for anything beyond some conservative estimation of liquidation value. But while it was once possible to find opportunities in the top-right cells (medium and large, certain MoS), today's asset-focused value investors find their cigar butts in the bottom-right cell (small, certain MoS).

Most contemporary value investors, including Warren Buffett and Charlie Munger, operate with a wider conception of value. They view intangible assets and the associated EPV as legit contributors to value, and by extension to margin of safety (MoS). They search for value in the middle column of the IW Box. The early Warren Buffett found numerous bargains in the top cell of the central column (large, relatively-certain MoS). Today, he and most other value investors have to settle for opportunities in the central cell (medium, relatively-certain MoS).

But even these contemporary value investors leave the uncertain value of earnings growth to "growth investors", who typically pay more attention to the quality of the business, or the growth prospects of the industry, than to the price paid, thereby renouncing to the risk control benefits of the MoS.

Think about it: most intelligent value investors consciously choose to operate outside the boundaries of the leftmost column. Those who operate within the column are for the most part self-styled "growth investors" who unknowingly place themselves in one of the lower cells, since the MoS is alien to their investment approach and they pay more attention to quarterly trends and YoY comps than to the price they pay.

The result is that in today's market, most investment opportunities can be found in the top-left cell (large, uncertain MoS).

At Investment Works, we believe that the size of the estimated margin of safety can more than make up for the uncertainty of the estimation.

We are willing to accept the estimated value of earnings growth as a third contributor to value, and by extension, margin of safety, provided that the contribution is sufficiently large.

The estimation of value of future growth within a franchise will always be far less certain (say 20%) than that of net working capital (say 90%). Yet a 120% MoS estimated with 20% certainty yields a larger expected MoS (24%) than a 20% MoS estimated with 90% certainty (18%). Given identical return prospects, we would rather take the 120% uncertain MoS than the 20% certain one. 

Applying the IW Box to the IW Portfolio

Here, we briefly apply the IW Box framework to the IW Portfolio, so that you can see it in action.

Along the process, we also hope to clarify a likely misconception. The IW Box may resemble a classical risk-reward curve, but it is distinctively different. It looks at the two dimensions of safety --MoS size and certainty, not at potential rewards. Among several opportunities with equivalent placement in the IW Box, the one offering the highest expected profit should be selected. And among several opportunities offering similar prospective rewards, the one with the safest placement in the IW Box should be pursued.

As already said, risk depends not only on MoS certainty (the horizontal IW Box axis), but also on its size (the vertical IW Box axis). And potential reward can be very different from expected MoS size. In fact, our favorite investment opportunities are those in which potential rewards handily exceeds MoS size.

A classical example is a business with credible plans of expansion within an existing franchise bought at a price somewhat below the value of current earnings power. In these cases, a moderate MoS substantiated by current EPV (the central box in the IW Box) can lead to a multi-bagger if the expansion plans pan out. While the MoS is given by relatively-certain EPV, the lions-share of the potential reward relies on growth at returns above cost of capital. Some of our investments have fallen in this category, including Nvidia (NVDA) and SolarEdge (SEDG). We bought them at a slight discount to EPV, yet the stocks have returned several times the price paid not because of the discount to EPV, but because of past and prospective growth within the bounds of strengthening competitive advantages.

An equally compelling investment opportunity is a business with underappreciated EPV and/or credible plans for profitable expansion, selling at a price below net asset value. Those are harder to find, but blend together in a most evident way the artificial boundaries of traditional "value" and "growth" investing. Air Lease (AL) presented such opportunity in January 2016.

A more common situation is found in the top-left cell of the IW Box. These are businesses with enormous profitable growth potential selling at a steep discount to the value of that growth. In these cases, the size of the expected margin shall more than offset the uncertainty in the estimation of value and by extension, of the MoS. Our investments in PayPal (PYPL), Tesla (TSLA) and, more recently, The Trade Desk (TTD), are examples in this group.

Often, the MoS is made of contributions from different sources of value. Take Apple (AAPL) in August 2015 as an example. The net cash position, together with EPV, added up to an intrinsic value well above the ongoing stock price. Likely future growth represented additional potential rewards, but it was not necessary to justify an investment with high standards of safety. Our more recent investments in Gilead Sciences (GILD), Foot Locker (FL) and L Brands (LB) are based on similar MoS considerations. Similar, the original MoS on PayPal was given mostly by EPV, but a smaller contribution from growth value was necessary to construct a sufficiently large margin of safety.

In the following figure, we place the current stocks in our portfolio in the IW Box at the time we initiated the positions.

Over time, both stock prices and business value change, which impacts the placement of a stock within the IW Box. Revisiting the placement of stock holdings in the IW Box helps inform portfolio allocation decisions.

The following is an approximate snapshot of how we see the MoS of our holdings as of April 2018.

We have maintained some holdings in their original cells. These are for the most part holdings added in the last 2 years that have not had yet time to close the gap between price and value. They are TTD, GILD, FL and LB. They remain in green cells and are therefore still regarded as BUY.

Commonly, especially during bull markets, successful investment holdings move over time towards lower cells along their original column, as increases in price more than offset increases in value. That has been the case with TSLA, PYPL, ATVI, PANW and AAPL. The price increases have brought these positions to red cells, which we regard as MAINTAIN, or if the risk-reward opportunity is no longer compelling, SELL (recall that rewards are not shown in the IW Box).

Less frequently, a holding can move across columns. NVDA and SEDG are no longer trading at a discount to NPV. To find a positive margin of safety, one needs to now look at the less certain value of growth. Similarly, AL no longer trades at a discount to net asset value. The margin of safety now relies on EPV.

We ask investors not to read too much into the specific placements of the positions in our portfolio given above. They have been provided mainly to exemplify the power of the IW Box framework. 

*This research piece was originally published in invworks.com