November 5, 2014

The Dolan Company and the True Meaning of Margin of Safety

Last week, during a leisurely morning read through the Wall Street Journal, I came across this headline:

“Hmm,” I thought to myself, “that company sounds familiar.” Oh yeah, it was a 5% position in my portfolio just a few months ago! Now it and its equity are worth nothing. Zip. Zilch. Just like that, a stock I argued was worth $5 in a sum of parts analysis was at $.02. A picture is worth a thousand words, so let’s take a look at the stock chart along with my entry and exit points:

chart

How could I have been so spectacularly wrong? Well for one, my thesis lacked an adequate margin of safety. Okay, we have all heard that term before but what does “margin of safety” really mean? Let’s start with what I have learned margin of safety is NOT: the difference between the current trading price and one’s appraised value. In my original post, I valued the Dolan Company (DOLNQ) at $5 per share, which measured against the $2.75 share price at the time, implied a 45% margin of safety.

The fatal flaw in this calculation is it ignores the balance sheet and the extreme effect leverage can have in the event of an unforeseen negative development. With this in mind, I would like to propose a more complete definition of the term: margin of safety is the amount a company’s enterprise value could decline and still be greater than all of the company’s debt and the price you paid for the stock (credit Geoff Gannon). Now, when we bring Dolan’s net debt of $4.55/share (as of June 30th, 2013), our calculation looks radically different: ($5-4.55)/2.75 = 16% – yikes!

While this definition gets us closer to assessing downside risk, I believe margin of safety must be also gauged qualitatively through negative scenario stress testing. Ask yourself, what could wrong with this business? What might happen to the equity if a recession strikes and revenues decline 20%? The scenarios chosen for your analysis should be severe, yet realistic.

In Dolan’s case, their litigation service business, DiscoverReady, was the only line growing and generating steady profits – the future of the firm rested on this division. Well, DiscoverReady had extreme customer concentration with 40% of their revenues derived from one client, Bank of America. Never mind the longstanding relationship, the question must be asked – what would happen if Dolan lost BofA’s business? You can do the math, but the loss of this client would have sliced the company’s operating profit in half and put their ability to meet interest obligations in question.

We all know how this story ended. Completely unexpected, the company reported a 21% decline in revenues, including a 33% decline at DiscoverReady in their Q3 release on November 21, 2013. As It turns out, Bank of America had become concerned about the company’s financial strength and stopped sending business to DiscoverReady. Dolan’s financial condition caused their business to deteriorate, which only worsened the financial condition – a death spiral that sent the stock from $3.00 to 0 in 5 months.

I was fortunate to see the impending danger in the company’s November 6, 2013 8-K filing that revealed Dolan’s lenders were requiring the company to raise $50M through asset sales or an equity issuance. With my thesis called into question, I exited the position literally hours before the company reported their Q3 earnings and endured a 50% stock price decline. Hardly deserving of congratulations, I suffered a 25% loss in a position that could have been avoided with proper assessment of the downside risk.

Demanding a margin of safety is essential to achieving long-term investing success, and though investors are familiar with the term, it is easily misused in practice. If you want to know the true margin of safety inherent in your investments, incorporate the company’s balance sheet and stress test your thesis. A company’s debt load and customer concentration can be gleaned from a 5-minute read through the 10-K and may save you from painful losses down the road. I paid a hefty tuition for these lessons and would be glad for you to learn at my expense!

Disclosure: No position