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Ben Graham’s Margin of Safety and Current Market Opportunities

When Coca-Cola replaced their classic formula with “New Coke” in 1985 the stock tanked, and when they brought back “Coca-Cola Classic” less than three months later the stock rebounded significantly.  Similarly, when McDonald’s had trouble with Chinese meat suppliers in 2014 the stock tanked, and since restoring customer confidence the stock has come roaring back.

Warren Buffett’s mentor, Benjamin Graham, coined the phrase “margin of safety” in his 1934 book “Security Analysis.”  Margin of safety is basically the difference between the intrinsic value of a stock and its current market price.  Investors with the vision to see through the short-term challenges (e.g. soda formulation and Chinese meat suppliers) are often able to profit significantly from the opportunities they create.

This week’s Stock of the Week was Chipotle Mexican Grill (CMG).  And as we noted in the report, this highly-popular, fast-growing, burrito-maker has suffered some recent setbacks (i.e. first comparable sales growth declined and then the E. coli outbreak happened).  However, this is a stock with some major growth potential, and the recent setbacks may be providing enough margin of safety for brave long-term investors to do something very smart (more on this later in this report).

 
 

As long-term McDonald’s investors, we’ve enjoyed the stock price rally (McDonalds is a Blue Harbinger 15 stock).  For example, it’s out-performing the S&P 500 by more than 20% this year, and that doesn’t even count the impressive 3.1% dividend yield (the S&P 500 yields only around 2%).  Additionally, we expect McDonald’s to deliver very strong earnings at its next earnings announcement on January 25, 2016 for two reasons (first the recent all-day breakfast will give earnings a boost, and second they updated their menus to more prominently display higher margin items and hide some of the lower cost items).  However, as the saying goes “buy low and sell high.”

We’ve been giving some serious consideration to swapping McDonald’s out of the Blue Harbinger 15, and replacing it with Chipotle.  Once the excitement of all-day breakfast slows, and once customers recognize the menu has been tweaked (to favor higher-priced items) then comparable sales will give back some of the “juice” we expect them to exhibit at the January 25th earnings announcement.  The wildcard for McDonald’s is foreign currency.  Unlike Chipotle, McDonalds faces significant headwinds related to the strong US dollar and their international operations (Chipotle is mostly US based, for now). However, rather than trying to forecast macroeconomic things like foreign currency exchange rates (no one gets those types of forecasts right more than 50% of the time anyway) we prefer to focus on things that are more predictable such as the slowing growth of the giant McDonalds compared to the accelerating growth of Chipotle.

Chipotle has declined about 30% since August 5th which may provide just enough “margin of safety” for us to buy into the high long-term growth potential of the company.  You can read a lot more detail on our views of Chipotle in our Stock of the Week report.  We’ll likely wait for a little more information on the E. coli outbreak and subsequent fallout/impacts.  However, we’ll post this information right away for Blue Harbinger members if we do end up swapping McDonald’s for Chipotle.

For reference, you can view our most recent updates and thesis for McDonalds here and here, respectively.


Continuing with the margin of safety theme, Two Blue Harbinger 15 holdings (American Express (AXP) and Union Pacific (UNP)) have been beat up significantly this year relative to the rest of the market.  But rather than running for the hills and selling the stocks, we continue to be long-term investors and we believe in the stocks going forward.  You can read more of our recent updates on UNP here and on AXP here.

 


Lastly, long-term investing is not just about buying things that have gone down, and selling things that have gone up.  You need to do your homework and understand the businesses.  And that is essential the whole point of Blue Harbinger Research.  Be smart.  You’ve worked hard to build your nest egg, and it pays to also work hard to protect it and to grow it.

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