Margin of Safety Applied: How to Avoid Getting Caught In Stocks Like TOPS (Totalindo Eka Persada)

Is it a good investment candidate? It depends on the price. That's pretty much the spirit of margin of safety, emphasized heavily first by Benjamin Graham, then value investors like Warren Buffett.

Value investing works of literature have made it clear the importance of having a margin of safety. There is a real danger by paying too much. In the long run, there is a good chance you never got your money back if you bought a stock at near its peak.

Properly applied, margin of safety is a vital concept that keeps you out of that trouble. This is a case study on how you can, using the right tools, avoid investing in stocks like TOPS and save yourself from permanent loss.

Margin of safety concept is simple: You buy the stock below what you think its price should be worth. It means you stay out when the market is overly optimistic and you get in when you think the market is overly pessimistic. It is a simple concept, but it requires some estimations. Value investors differ in how we estimate things, but our goal is the same. I'll show you how I do mine.

I often find new investors have little regard for the concept of margin of safety. They are charmed by 'economic moats' and 'rosy futures'. But unlike popular beliefs, margin of safety is a timeless concept. Let's see how that applies to TOPS.

---

TOPS is a construction company that builds Mall Taman Anggrek. Its share price went from 1.000/share in 2018 to 50/share now. Some of my friends (and many) bought it near its peak (around 800) because of an ill-sounded methodology called 'bandarmology'. Bandarmology analysis shows that a certain 'bandar' has been accumulating it, so the logic of the theory says, TOPS share price is bound to appreciate. Just another bad theory in the stock market that leads to a destructive outcome. And apparently, bandarmology is still alive and well here, and those who got caught blamed it on the negotiated market.

Let's get started for real. We all know that TOPS real performance is bad. You can see it easily with EVA. It went from being a value creator to value destroyer shortly after its IPO in 2017.

However, it's not enough to know the performance of the company. We also need to know how the market is valuing that performance.

Think of the value of a company as its capital already invested plus a string of EVA that is expected in the future. Because the capital is already known in the balance sheet, our job is to estimate that string of EVA.

Most of the time, I don't forecast EVA far into the future. I let that task to the market. I simply ask, given the share price, how much growth of EVA is being expected by the market? This process is called reverse-engineering DCF. It is one of the best ways to eliminate our many biases.

In 2017, TOPS share price started at around 120/share. Its EVA was IDR 68 Billion. To justify its share price, TOPS needs to grow its EVA from IDR 68 Billion to IDR 426 Billion in 5 years. That is at the pace of EVA momentum of 3% per year. Quite reasonable at that time.

As it turns out, EVA slumped in 2018. EVA momentum was -8.2%. But that did not stop investors from dreaming that somehow TOPS could get IDR 4,5 Trillion (!!) economic profit in the next five years. That's ten times last year. They expected TOPS could get EVA momentum of 64% per year for the next five years. What's the global average? Around 1%.

Let's put this graphically. The number 0 is the real data (starting point). Number 1-5 is the expected (implied) EVA to justify its share price at that time (2018 share price at the peak of IDR 950/share).

So where is the margin of safety here?

Back in 2017, you just saw that at the share price of IDR 120/share, investors are expecting EVA momentum of 3% on average. That is a pretty high expectation already. If you think TOPS could manage to get EVA momentum of 6%, its share price would be worth at least IDR 190/share. That gives you at least a 50% return on investment potential if you are correct. If TOPS falls short of 6%, you are still good to go. Even if TOPS could 'only' get EVA momentum of 3%, the reward is still good because that means TOPS manages to meet investors' expectations. More often than not, investors would still rise the share price substantially if their expectations are met (and more if exceeded).

A cynical value investor might consider TOPS EVA to decline in 2018 (which is right). If he/she believes that, he/she has no compelling reason to invest in TOPS even when its share price was at IDR 120/share. There is already no margin of safety. Yes, that investor lost the opportunity to earn big on TOPS, but also spared the tragedy of permanent loss. In 2018, TOPS share price was almost IDR 1,000/share. Look at the chart above once more. There is no margin of safety there because no amount of rationalization is adequate to justify that share price. There is almost no way any company could get EVA momentum of 64% in any year. From time to time, there is this kind of stock that is being pushed beyond imagination. And every single time, that kind of stock would plummet hard and fast, often to the point of worthless.

Most people rely on PE and PBV for gauging margin of safety. Although there is no way such simple ratios could explain anything fundamental, I prefer PBV and disregard PE as PBV is more linked to value in theory (and practice). In another time, I'll discuss it in detail.

The chart above is Enterprise Value/Capital. It is a slightly enhanced version of PBV. Most people would notice that in 2018 it was really high signaling excessive optimism, and that leaves no margin of safety. But as explained above, EV/Capital in 2017 turned out to be too high as well, realistically speaking.

Investors who take seriously margin of safety would surely avoid investing at TOPS in 2018. Some conservative investors might also rightly choose not to invest in 2017. The idea that the conservative (but, right) investors are likely to miss TOPS dramatic surge in 2018 might discourage some readers. Some would say value investing is outdated or some version of 'this time is different'. But time will not be kind to such beliefs, historically speaking.