Portfolio Weighted Discount to Intrinsic Value

I try to invest in companies that are selling at a large discount to the intrinsic value. This discount to intrinsic value is the margin of safety I require before I invest in any stock to guard against any incorrect predictions and assumptions. I typically adhere to a strict 30-35% margin of safety to conservative estimates of intrinsic value. Over the weekend, I wanted to evaluate the discount to intrinsic value of my whole portfolio to confirm my suspicions that I need to rebalance my portfolio, which is heavily concentrated in Microsoft stock.

To do this, I multiplied my estimates to the discount to intrinsic value for each company by the portfolio weight of the position. For example, I estimate MSFT's current margin of safety to be about 10%, meaning I think the shares are worth about $33 dollars compared to the current price of $30. Because 20% of my portfolio is in Microsoft, the 10% margin of safety gets multiplied by .20. Summing up the weighted margins of safety across all my positions gives me a current portfolio weighted discount to intrinsic value of about 18.75%. For me, a margin of safety in the teens is not desirable. I would much prefer to have a portfolio margin of safety around 25%.

In a tax-free and commission-free world, investors should replace stocks with low margin of safety with stocks that have high margin of safety, thereby raising the portfolio margin of safety. Looking down my portfolio, the following stocks have margins of safety below my weighted portfolio margin of safety of 18.75%: DRL, ACUS, MSFT, BUD, PFE, HD, JBSS, ENH, and MMM. These are sorted from lowest to highest margins of safety. As a first step, I've already sold off DRL and ACUS, because these are moonshots with questionable margins of safety. Unfortunately, these were very small positions that had negligible impact on the portfolio margin of safety. Swapping Microsoft with high margin of safety companies will have a much larger impact.

Although selling Microsoft and replacing it with my current best ideas with the highest margins of safety will automatically give me greater than 25% portfolio margin of safety, I am hesitant to make such a drastic change. Microsoft had a huge 40% run in the latter half of last year, but most of my gains are still short-term. Short-term capital gains will eat away a lot of my profit and I'm not convinced that Microsoft won't give above average returns even if it is fully valued. Out of all the positions listed, only BUD and ENH have long-term gains and some shares of MSFT, MMM, and PFE are long-term. At the end, I decided to sell off 30% of my position in Microsoft. With this money, I will buy more shares of Chesapeake Energy and USG Corporation, my current best ideas. This portfolio rebalancing should put me over 20% portfolio margin of safety. More modifications will need to be made this year, but there is no rush. These stocks with low margin of safety are all very high quality companies.

The portfolio margin of safety is not an easy number to calculate. You need the margin of safety of every position before you can calculate it. I recently did this for my whole portfolio and it took me the whole Saturday. Despite the laborious number crunching, I find this very useful for making rebalancing decisions. The large amount of work is also incentive to run a more concentrated portfolio of one's best ideas. As the year goes by, I will give more thought to unraveling some of my smaller positions.