Saturday, January 21, 2012

My definition of Margin of Safety

Margin of Safety is a very important concept in the field of value investing and of course comes from no other than our dear Benjamin Graham. In the Intelligent Investor, he mentioned that "margin of safety is always dependent on the price paid". Basically, if the intrinsic value is $1, you should purchase the stock at as much a discount as possible. Do note that intrinsic value and book value are not the same. The reason why margin of safety is needed is because that we are always susceptible to a huge downturn or error in judgement. Should anything happen, losses will be limited as we have bought it at a discount. However, the crucial part in the calculation of margin of safety lies in the estimation of intrinsic value, which makes it very very dangerous for those untrained or inexperienced, like me. Valuation methods differ from comparable, DCF, PE, PB and more than often using of different methods give you different intrinsic value. This is one reason why I never try to do valuation (I will try to learn though) for my stock. So how should the layman ensures his margin of safety? Here is how I do it:

Never Overpay
I will be very careful whenever the PE is more than 15 and will very likely not consider it at all if the PE is more than 20. This only works for company that has regular products and services being sold, else I will have bought into OUE whose PE is 2. For companies in the property sector or whose income is highly dependent on their assets, P/B will be more useful. P/B can also be used for banks and financial company as they essentially depend on borrowed money and lending it out. Discount to P/B differ for different sector, thus it will be better if one will to compare it with the sector and their historical P/B value.

Research and Understand the Company
Knowing as much as possible about the company that you buy into is very important. Be it whether it is in your circle of competence, one should at least understand the type of products and services that the company provides, its market share, competitors and the industry at large. In such a case, one will be able to react well should anything unexpected happen like maybe a lawsuit, new competitor, recession and e.t.c. If sufficient research is done, one will be able to sleep well at night without fearing the unknowns. This is also a criteria for you to be able to take advantage of Mr Market, by understanding about the company more than your fellow shareholder.

Good Business Model confirmed with Financial Statement Analysis
With a good business model, a company will be able to maintain its profit in almost all circumstances. So long as a company is able to grow its bottom line, its intrinsic value will be achieved sooner or later. As Warren Buffett says "You should invest in a business that even a fool can run, because someday a fool will". Thus, after you have identified a good business model, you should start to examine its past annual report and financial statement. If the business model is indeed sound, it will usually be confirmed by the financial statements like consistent profit growth, high profit margin, net cash, high ROE and e.t.c. If the analysis proves otherwise, it only means two things: 1) A fool is indeed running the business or 2) The business model is not as sound as you think it is.

Intention to hold it for a significant period of time
Having a long term view is important since more than often we are never that fortunate to pick a stock when it reaches its lowest point. If you have abide by the above three principles, the last thing that you need to do is to hold it out so long as the initial reason for the purchased is unchanged or wrong. Just like an antique collector that knows the worth of his collection, he will never sell it at a discount even if you may try to convince him that it is overvalued. What he will do will be to wait until he is being offered a price that he deemed fit. Similarly, the market might offer you a deserving price only in the long run, perhaps years.

These I believed will be much more meaningful than trying to calculate the intrinsic value and hence the price that you should buy a stock.

4 comments :

  1. It's unusual but fantastic for one as young as you to start thinking investing (and not trading). Keep it up!

    I'm also new to investing and have been 'lucky' so far. I'm now trying to learn to invest properly hehe. Still reading "The Intelligent Investor".

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    1. Thank You, with enough efforts put in, I believe everyone can do it.

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  2. good stuff keep it up..
    i'm a young investor like you,i still have alot to learn though i have only been in the business for 6 months
    i love your stuff post some more!!

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    1. Well, I have also only been in it for slightly less than a year. Youth is our greatest advantage and time is our best leverage. I am sure we will enjoy this journey a lot for the rest of our lives :)

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