As a value investor, I always want to have a margin of safety to protect me when I purchase an asset. This margin of safety is really a margin for error. You need this margin for error to prevent you from paying more than the company is actually worth. In my next few blog postings I will demonstrate different ways to purchase that kind of margin. Today’s discussion is about certainty.

At Baskin Financial we always look to buy certainty. The margin of safety comes from purchasing companies that sell products that will be in certain need in the future. For example, I am certain that when I wake up tomorrow, I will brush my teeth, take a shower, eat, use the bathroom, clothe myself, get to work, eat again, come back home, eat again and go to sleep. Companies that help billions of people like me take care of these basic needs will provide a margin of safety. However, investing in the latest technology idea or fashion fad does not provide you with a margin of safety.  I don’t want to wake up tomorrow to find out that my $150 yoga pants are out of style.

I find it curious when investors reward companies with uncertain futures a high valuation. Take Netflix, for example. Netflix is in the business of offering unlimited DVD rentals by mail for a flat monthly fee. They also recently began offering streaming video for a flat fee, which gives its customers access to over 20,000 hours of video on demand. However, competition is fierce, with Apple, Google and Amazon, as well as cable providers also offering on demand programming—sometimes for no extra cost. Of course Netflix has the first mover advantage, and with 20 million customers, it has become a brand name. Based on consensus estimates, Netflix is expected to grow its earnings 50% in 2011 and another 50% in 2012. This is indeed fantastic growth. But an investor buying Netflix today is paying a lot for that expected growth. At its current price, Netflix is trading for 50 times its 2011 expected earnings per share. To put that number in perspective, the average company on the S&P 500 is trading at 13 times 2011 earnings. At some point in time, Netflix will no longer grow its earnings by 50% a year and it will revert to more normal multiple of 13 times earnings. You don’t want to own shares in Netflix when the mean reversion starts.

What if I told you that instead you could invest in a company that is also expected to grow its earnings by 50% this year, has a product that is in limited supply and cannot be substituted and demand should continue to grow for decades. And to top it off, this company is trading at eight times cheaper than Netflix. Now that’s a margin of safety.

This company is Vale: a diversified mining company out of Brazil. Vale, while not a household name, is one of the largest mining companies in the world. It sells numerous different resources, and it has the most exposure of any major miner to iron ore. Iron ore is the key ingredient in steel production. This key ingredient has helped Vale generate $46 billion in revenue in 2010 and should power earnings per share to around $5 in 2011.  At its current price of $32, Vale is trading at 6.4 times earnings. Worldwide steel production increased 15% in 2010 and should continue to grow in 2011. Outside of the U.S., the two other biggest producers of steel, China and India, do not have plentiful resources of iron ore. To meet the Asian demand, Vale will spend $24 billion in 2011 to increase its iron ore output and spend a total of $92 billion by 2015 to double its current production of resources. Vale also intends to fund all of its capital expenditures with internally generated cash flows.

Iron ore has been used for over 5,000 years, and I am fairly certain that it will be utilized for many more years to come. We cannot say with any certainty whether Netflix’s streaming video operations will be as long lasting.

Disclosure: clients of Baskin Financial own shares in Vale.

Seeking Alpha Certified