Want Safety? Look for Growth and Value Together

• BySham Gad, RealMoney Contributor
• On 3:45 pm EST, Tuesday November 3, 2009

Most investors, especially value investors, are familiar with the general concept of margin of safety, a term first coined by value investing legend Benjamin Graham. The concept is a safeguard for investors from abrupt or short-term shocks in the business or economy -- the goal is to buy shares of stock below intrinsic value.

Many investors take this concept as simply buying a dollar's worth of assets for substantially less -- the proverbial "50-cent dollar" often praised in value investing circles. While that idea is a very intelligent and rational way of selecting investments, it falls short of really achieving the ultimate protection sought by investors looking for a margin of safety.

Value + Growth = Margin of Safety

The first aspect of margin of safety, and the one most relied upon by many value investors, comes from the balance sheet, which is certainly an appropriate place to start. Many investing mistakes arise because investors focus far too much on the income statement and not enough on the balance sheet. For decades, investors were enamored by the growth of financials and based all future projections on profit without paying attention to the changes occurring on the balance sheet.

So the first element of safety you should seek out in a business is indeed the balance sheet. Without a quality balance sheet, the most profitable of businesses can crumble under a temporary period of economic distress. Remember Lehman, Bear Stearns and Countrywide?

But once you have that first moat around a possible investment, focus on the earnings power of the business. While a quality balance sheet may prevent the stock price from going down precipitously, without earnings growth, the stock price may never go up. So the growth component of a business also becomes a very crucial margin of safety, but only when considered alongside a sound financial position.

Businesses with these two attributes provide the most compelling margin of safety over the long run. Couple that safety with an attractive stock price, and you are likely to be satisfied with your long-term investment performance.

Consider a business like St. Joe , one of the largest private land owners in Florida. The market currently assigns it a market valuation of $2.2 billion, while the balance shows a debt balance of $50 million and cash balance of $117 million. For land businesses, debt is deadly because raw land isn't producing income to service that debt. For that $2.1 billion EV, you're getting more than 550,000 acres, 90% near or on the beach. That's a very cheap price for these irreplaceable assets -- just over $3,800 an acre on average.

The land business is tough today, so Joe's pristine balance sheet is a big advantage. At the same time, the intrinsic value of land means Joe should have no problem monetizing the land over time, leading to earnings growth. Case in point -- Joe donated the land for the new Panama City airport opening next year in Florida, but it still hols all the surrounding tracts -- it stands to make a killing from hotels, restaurants and similar service establishments.

While other land-rich companies like Forest City Enterprises also pose interesting value bets (noted value investor Marty Whitman owns shares of FCE), the quality of the balance sheet could not be relied on in times of distress.

As another "margin of safety" play, consider MVC Capital , a business development company that specializes in acquisitions and financing of middle market companies. The market cap is $227 million, or $9.35 a share, against stated net asset value of more than $17 a share. In fact, management just this morning issued a release that the aggregate value of the fund's investments increased by $1.33 a share at the end of October.

MVC is not highly levered; its portfolio is nearly two-thirds equity and the shares currently yield 5.3%. Chairman and portfolio manager Michael Tokarz receives no salary and an incentive of 20% for any realized gains. At a nearly 50% discount to net asset value, this stock is trading at one of its largest discounts ever, and you can rest assured management is considering how to fix this discrepancy. MVC invests in old-economy businesses, many that have been around for decades.

The big risk of course, is taking management's assessment of NAV at face value. (If this company were trading at 20% of NAV, I probably wouldn't be writing about it.) Management owns more than 11% of outstanding shares, a small sign of alignment of incentives. The discount in NAV protects you from some unexpected adjustments. The dividend along with the fair pay structure gives management every incentive to grow the value of the business.

All investing entails risk. Focusing on the balance sheet can help eliminate a lot of that risk, but an investor's greatest margin of safety comes when a sound business chugs ahead with a functioning earnings engine.

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Please note that due to factors including low market capitalization and/or insufficient public float, we consider MVC to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

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