Value Investing - Margin of Safety

Safety Margin  


Consider a real-life example of a margin of safety. Say you're planning a pyrotechnics show, which will include flames and explosions. You have concluded with a high degree of certainty that it's perfectly safe to stand 100 feet from the center of the explosions. But to be absolutely sure no one gets hurt, you implement a margin of safety by setting up barriers 125 feet from the explosions.

This use of a margin of safety works similarly in value investing. It's simply the practice of leaving room for error in your calculations of intrinsic value. A value investor may be fairly confident that a company has an intrinsic value of $30 per share. But in case his or her calculations are a little too optimistic, he or she creates a margin of safety/error by using the $26 per share in their scenario analysis. The investor may find that at $15 the company is an attractive investment, or he or she may find that at $24, the company is not attractive enough. If the stock's intrinsic value is lower than the investor estimated, the margin of safety would help prevent this investor from paying too much for the stock.

http://www.trade4rich.com/SaftyMargin.html

Margin of Safety

"Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY."

- Ben Graham

Efficient Market Hypothesis: Fact Or Fiction? "Efficient" refers to informational efficiency only.

The efficient markets hypothesis (EMH) in all of its forms, whether strong, semi-strong, or weak, is normative, not positive, i.e., it is an assertion about the way markets should behave in an ideal, utopian world, not a statement about the way markets actually do work in the real, practical world. Simple observation shows that the EMH in all its forms is fallacious. Both Kindleberger and Mackay give historical examples of stock market irrationality and inefficiency.

The efficient markets hypothesis may have advanced many academic careers, but it has not demonstrably increased the wealth of any investor over what would have been created otherwise. The EMH and the related capital asset pricing model, as opposed to the operating enterprise valuation model, may be useful as a standard of market perfection in studies of the market as a whole, but not in the valuation or selection of common stocks for investment.

The term "efficient" in the efficient markets hypothesis refers to informational efficiency only. It does not include mechanical operational efficiency or necessarily societal welfare efficiency.

The EMH explicitly assumes that all market participants have access to the same information in either a strong, semi-strong, or weak sense of the hypothesis.

• This simplifying assumption is chosen because it is necessary for mathematical tractability and thus highly convenient. 
• What makes this assumption unacceptably implausible is the meaning of the term "information" which is often overlooked. 
• Data is not information. Rather, information is data that has been processed and interpreted with judgment based on intelligence, knowledge and experience. 
• Does anyone believe that all market participants are endowed equally, not with access to data, but with the same intelligence, knowledge and experience? 

Competitive, properly-regulated markets may approach the semblance of "data efficiency" in the relative sense of eliminating arbitrage opportunities subject to trading costs and taxes, but no market is efficient in any absolute sense of equating price at all times to intrinsic economic value. This margin between value and price is the major key to successful value investing.

Margin of Safety

Intrinsic value is independent of the market and current quoted price. 


It is the absolute standard against which all market prices are compared. 

• Thus with the method of valuation, companies are considered neither under-valued nor over-valued relative to the stock market. 

This would be bringing truth to error for correction, a backward approach. 

• Rather, common stock issues are considered either under-priced or over-priced in the market relative to the intrinsic value of their companies. 

This brings error to truth for correction. 

• To identify mispriced stocks, the value of a company is compared to its stock market price.

The concept of price is not without ambiguity. 

• We can choose among closing price, opening price, asking price, bidding price, actual price of latest trade for any number of shares, or actual price of latest trade for the same number of shares in the contemplated transaction.

Thus we focus on the important concept of safety margin rather than emphasize price with its potential quick and large changes from one transaction to the next. 

• The variability of the price of a stock in part represents mispricing by the market. 
• Such lack of convergence of market price to intrinsic value, however transient, represents market inefficiency. 
• The irrationality of the stock market has been observed by de la Vega, John Maynard Keynes, Kindleberger, Lefèvre, Mackay, and others.

John Maynard Keynes in his General Theory (Book IV "The Inducement to Invest", Chapter 12 "The State of Long-Term Expectation", Section V, pages 156-157) introduced the metaphor of newspaper photograph competitions to explain the working of the stock market. 

• His explanation emphasized anticipation of the opinions of other market participants and the resulting infinite regress, i.e., I think that he thinks that I think that he thinks, ad infinitum. 
• This stresses that market prices are determined by opinion.

Safety margin represents an excess of intrinsic value over market price, or alternately, a discount of price below intrinsic value. 

• A safety margin of at least twenty percent is desirable. 
• Intrinsic value is what a company would be worth to a private owner independent of the stock market and its daily quotations. 
• The concept of a margin of safety was introduced by Graham and Dodd in Security Analysis. 

It is more important to wait for a favorable buy price than to be dependent on fortuitous timing to realize a profitable sell price. 

• A buy and hold approach involves more than the platitudinous adage to "buy low and sell high." 
• The margin of safety requires knowing when the buying price is low in absolute terms rather than merely relative to the market as a whole.

http://www.numeraire.com/margin.htm

Price is not value, pricing is not valuation, and pricing models are not valuation models.

A valuation model is an effective method for estimating economic value.


Another term that is used to refer to economic value is "fundamental value", which derives the quantity of value from so-called fundamental economic metrics generated by a firm at the firm-level, in contrast to pricing metrics generated by a securities market at the security-level. 


Price is not value, pricing is not valuation, and pricing models are not valuation models. 


The conventional academic capital asset pricing model has one factor, the beta coefficient. 

• Models that include beta are pricing models, not valuation models. 
• This is not merely a matter of semantics. 

The difference between price and value, referred to as the margin of safety, is the raison d'etre of investment valuation independent of market pricing.


http://www.numeraire.com/value.htm

The investor's concept of a margin of safety

 The investor's concept of a margin of safety rests upon a simple and definite arithmetical reasoning from statistical data.

1. There is no guarantee that the fundamental quantitative approach will be successful in the future, but no reason for pessimism. 
2. "To have a true investment there must be present a true margin of safety." 

"It is our argument that a sufficiently low price can turn a security of mediocre quality into a sound investment opportunity--provided

• that the buyer is informed and experienced and 
• that he practices adequate diversification. 

For if the price is low enough to create a substantial margin of safety, the security thereby meets our criterion of investment.


http://www.conscious-investor.com/books/intelligentinvestor.pdf

HOW WARREN BUFFET DETERMINES A FAIR PRICE

The real secret of Warren Buffett is the methods that he uses, some of which are known from his remarks, and some of which are not, that allow him to predict cash flows with some probability.

Various books about Warren Buffett give their explanations as to how he calculates the price that he is prepared to pay for a share with the desired margin of safety.

• Mary Buffett and David Clarke pose a series of tests, based on past growth rates, returns on equity, book value and government bond price averages.
• Robert G Hagstrom Jnr in The Warren Buffet Way gives explanatory tables of past Berkshire Hathaway purchases using a DCF model and owner earnings.

Ultimately, the investor must decide upon their own methods of arriving at the intrinsic value of a share and the margin of error that they want for themselves.

INTRINSIC VALUE: THE RIGHT PRICE TO PAY

INTRINSIC VALUE

Both Warren Buffett and Benjamin Graham talk about the intrinsic value of a business, or a share in it.  That is, to buy a business, or a share in it, at a fair price. 

But, having regard to the possibility of error in calculating intrinsic value, the careful of investor should provide a margin of error by only buying the business, or shares, at a substantial discount to the intrinsic value.

Buffett is said to look for a 25 per cent discount, but who really knows?

DEFINING INTRINSIC VALUE

Buffett’s concept, in looking at intrinsic value, is that it values what can be taken out of the business. 

He has quoted investment guru John Burr Williams who defined value like this:

‘The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.’ – The Theory of Investment Value.

The difference for Buffett in calculating the value of bonds and shares is that the investor knows the eventual price of the bond when it matures but has to guess the price of the share at some future date.

BENJAMIN GRAHAM - THE MARGIN OF SAFETY

Benjamin Graham tells us that investment policy can be reduced to three simple words: "Margin of Safety" - the price at which a share investment can be bought with minimal downside risk.

The important point here is that the margin of safety price is not the same as the price that an investor calculates a share to be intrinsically worth.

THE INTRINSIC VALUE OF A SHARE

An investor may calculate the intrinsic value of a share by differing methods and will eventually come up with a price that he or she believes represents good buying value. Graham had his methods of calculating intrinsic value, Warren Buffett has his, other successful investors have theirs.

Graham acknowledges, however, that calculations may be wrong, or that external events may take place to affect the value of the share. These cannot be predicted. For these reasons, the investor must have a margin of safety, an inbuilt factor that allows for these possibilities.

PRIME BONDS VS GOVERNMENT BONDS

For Benjamin Graham, the benchmark for calculating the margin of safety was the interest rate payable for prime quality bonds. As Graham wrote in an era when prime bonds were much more prominent, it is more practical now to adopt, as Warren Buffett apparently does, the rate of return of government bonds as the benchmark.

Graham then uses a comparative approach. If the risk in two forms of investment is the same, then it must be better to take the investment with the higher return. Conversely, an investment with higher risk, such as shares, should, when calculating the margin of safety, have a higher return

EXAMPLE

Modifying then the example that Benjamin Graham uses in his book, we can take a share investment that is yielding 10 per cent earnings. For example, company A is earning 90 cents per share and is selling in the market at 10 dollars. If the rate of return on government bonds is 5 per cent, then the share is yielding annually an excess of 5 per cent. Over a period of ten years, the excess yield will total about 50 per cent, which, in Graham’s opinion, may be enough, if the share investment was wisely chosen in the first place. Of course, the total margin of safety will fluctuate depending upon the quality of the share investment.

Even so, something may go wrong. Graham believes however, that, with a diversified portfolio of 20 or more representative share investments, the margin of error approach will, over time, produce satisfactory results.

 ACCORDING TO BENJAMIN GRAHAM:

"[To] have a true investment, there must be a true margin of safety. And a true margin of safety is one that can be demonstrated by figures, by persuasive reasoning, and by reference to a body of actual experience".

http://www.buffettsecrets.com/margin-of-safety.htm

Warren Buffett Secrets

http://www.buffettsecrets.com/index.htm

Unlike return, risk is no more quantifiable at the end of an investment than it was at its beginning.

While security analysts attempt to determine with precision the risk and return of investments, events alone accomplish that.

Unlike return, however, risk is no more quantifiable at the end of an investment than it was at its beginning.

Risk simply cannot be described by a single number.  

Intuitively we understand that risk varies from investment to investment:  a government bond is not as risky as the stock of a high-technology company. But investments do not provide information about the risks the way food packages provide nutritional data.

Rather, risk is a perception in each investor's mind that results from analysis of the probability and amount of potential loss from an investment.

• If exploratory oil well proves to be a dry hole, it is called risky.  If a bond defaults or a stock plunges in price, they are called risky.  
• But if the well is a gusher, the bond matures on schedule, and the stock rallies strongly, can we say they weren't risky when the investment was made?  

Not at all.  The point is, in most cases no more is known about the risk of an investment after it is concluded than was known when it was made. 


There are only a few things investors can do to counteract risk:

• diversify adequately, 
• hedge when appropriate, and 
• invest with a margin of safety.  

It is precisely because we do not and cannot know all the risks of an investment that we strive to invest at a discount.  The bargain element helps to provide a cushion for when things go wrong.

Value Investment Philosophy

Value investing is the discipline of buying securities at a significant discount from their current underlying values and holding them until more of their value is realized. The element of a bargain is the key to the process. In the language of value investors, this is referred to as buying a dollar for fifty cents. Value investing combines the conservative analysis of underlying value with the requisite discipline and patience to buy only when a sufficient discount from that value is available. The number of available bargains varies, and the gap between the price and value of any given security can be very narrow or extremely wide. Sometimes a value investor will review in depth a great many potential investments without finding a single one that is sufficiently attractive. Such persistence is necessary, however, since value is often well hidden.


The disciplined pursuit of bargains makes value investing very much a risk-averse approach. The greatest challenge for value investors is maintaining the required discipline. Being a value investor usually means standing apart from the crowd, challenging conventional wisdom, and opposing the prevailing investment winds . It can be a very lonely undertaking. A value investor may experience poor, even horrendous , performance compared with that of other investors or the market as a whole during prolonged periods of market overvaluation. Yet over the long run the value approach works so successfully that few, if any, advocates of the philosophy ever abandon it.

A notable feature of value investing is its strong performance in periods of overall market decline.

Whenever the financial markets fail to fully incorporate fundamental values into securities prices, an investor's margin of safety is high.

• Stock and bond prices may anticipate continued poor business results, yet securities priced to reflect those depressed fundamentals may have little room to fall further. 
• Moreover, securities priced as if nothing could go right stand to benefit from a change in perception. If investors refocused on the strengths rather than on the difficulties, higher security prices would result. 
• When fundamentals do improve, investors could benefit both from better results and from an increased multiple applied to them.

Example:


In early 1987 the shares of Telefonos de Mexico, S.A., sold for prices as low as ten cents. The company was not doing badly, and analysts were forecasting for the shares annual earnings of fifteen cents and a book value of approximately seventy-five cents in 1988. Investors seemed to focus only on the continual dilution of the stock, stemming from quarterly 6.25 percent stock dividends and from the issuance of shares to new telephone subscribers, ostensibly to fund the required capital outlays to install their phones. The market ignored virtually every criterion of value, pricing the shares at extremely low multiples of earnings and cash flow while completely disregarding book value.

In early 1991 Telefonos's share price rose to over $3.25. The shares, out of favor several years earlier, became an institutional favorite. True, some improvement in operating results did contribute to this enormous price appreciation, but the primary explanation was an increase in the multiple investors were willing to pay. The higher multiple reflected a change in investor psychology more than any fundamental developments at the company.




Ref:  Margin of Safety by Seth Klarman

Should investors worry about the possibility that business value may decline? Absolutely.

The possibility of sustained decreases in business value is a dagger at the heart of value investing (and is not a barrel of laughs for other investment approaches either). Value investors place great faith in the principle of assessing value and then buying at a discount. If value is subject to considerable erosion, then how large a discount is sufficient?

Should investors worry about the possibility that business value may decline? Absolutely. Should they do anything about it? There are three responses that might be effective.

• First, since investors cannot predict when values will rise or fall, valuation should always be performed conservatively, giving considerable weight to worst-case liquidation value as well as to other methods. 
• Second, investors fearing deflation could demand a greater than usual discount between price and underlying value in order to make new investments or to hold current positions. This means that normally selective investors would probably let even more pitches than usual go by. 
• Finally, the prospect of asset deflation places a heightened importance on the time frame of investments and on the presence of a catalyst for the realization of underlying value. In a deflationary environment, if you cannot tell whether or when you will realize underlying value, you may not want to get involved at all. If underlying value is realized in the near-term directly for the benefit of shareholders, however, the longer-term forces that could cause value to diminish become moot.

Ref:  Margin of Safety by Seth Klarman

Seth Klarman and Margin of Safety

Seth Klarman

Brief Biography

Seth Klarman is a leading value investor. Mr. Klarman is the President of The Baupost Group, a Boston-based private investment partnership which manages over $7bn in assets on behalf of private families and institutions. Founded in 1983, the firm has achieved investment returns of 20% compounded annually. The firm invests in equities, distressed debt, private equity and real estate. Mr. Klarman is notable for his willingness to hold significant amounts of cash in his investment portfolios, sometimes in excess of 50% of the total. In 1991, Mr, Klarman authored Margin of Safety, Risk Averse Investing Strategies for the Thoughtful Investor, which since has become a value investing classic. Now out of print, Margin of Safety has sold on Amazon for $1,200 and eBay for $2,000. Before founding Baupost, Mr. Klarman previously worked for Max Heine and Michael Price of Mutual Shares. Mr. Klarman is a graduate of Cornell University and Harvard Business School.

http://valuestockplus.wordpress.com/seth-klarman/

Click here for a pdf copy of this book.
http://www.my10000dollars.com/MS.pdf

7 Important Stock Investing Advice from Warren Buffett!

Summarized Overview

In this article, you’ll find information on the stock investing ideas that Warren Buffet wants all stock investors to know, strategy he uses to maximize return, price of stocks that he willing to pay, key financial ratio that is so important to him, type of managers he loves, and kind of management he trusts.

7 Stock Investing Advices for Beginners

This stock market investing advice will help you on how to pick stocks Warren Buffet way.

Stock Investing Advices #1: Simple Business Model

You must understand the business itself or at least like and use it. Warren Buffett likes to patronize/use Nike, Coke and Gillette products and he is a believer of his investments. Have time to read and study the business model and the financial reports that takes only 2-3 hours per day. Invest as if you will buy the business.

Do you know why this is so important?

When come to investing, predicting what will happen tomorrow is something that you can’t live without. Forecasting what the future will be is the only way you can estimate how much return you’ll be getting later on. So, if you really understand the business inside out, you can project how the company performs 30 years down the road; take into consideration the national economy, competition from others and change in customers’ lifestyle.

Most companies here in Philippines have investor relation’s page in their websites where you can browse their financial reports.

Stock Investing Advices #2: Wide Economic Moat

In simple terms, it must dominate its market and can somehow dictate its product’s prices. Warren Buffet himself avoids regulated industries, commodity businesses as well as capital intensive industries. Look out Nike, it has its own market around the world and it can dictate its own product prices regardless of its competition because people buy Nike for its brand. Further, company should finance its capital from operating cash flow and not depending on borrowings. That is why, Warren Buffet love ‘franchise’, for example, Furniture Mart (the lowest cost in the industry), The Washington Post (market dominance and leader), Coke (strong brand name) and Candies (premium priced and high quality products that serve niche market).

How about Jollibee or Meralco here in our country?

Stock Investing Advices #3: Sustainable Growth

Serving the existing niche market is not enough. Instead, Warren Buffet wants the company to grow continuously and exponentially. Therefore, he looks for managements that have the ability to widen their economic moat consistently over the past years. Their businesses must be positioned where the demand able to grow continuously; Gillette is his best example. In the same time, always be ready for any possible trouble to the business, and most importantly back up your investment plan!

Have you heard of the recent plans of San Miguel Corporation and Metro Pacific Investment Corporation?

Stock Investing Advices #4: Excellent Capital Management

The Management should utilize the available resources for the highest return to the company and to its shareholders. Shareholders should be benefited for their investments thru dividends. Management carries the trust of the shareholders, thus, they should act and think as owners too. Moreover, it is better if the management holds a huge number of stocks too, since they will act as true owners and will not think short term but instead, will make sure that the company earns in the next 20 years or more!

Stock Investing Advices #5: Effective Management Team

Invest in company that has honest and capable managers. They should be so capable that Warren Buffet himself admires the way the managers do things. In Berkshire Hathaway Annual Meeting year 2000, he once said, “we want managers who tell the truth and tell themselves the truth, which is more important”. He loves cost conscious and frugal type of managers who are honest and integrity as well.

Stock Investing Advices #6: Superior ROE

The general rule that it is above 15! Why ROE, and not the other financial ratios? Well,return on equity indicates how effective the management team converts the reinvested money into cash. The higher the return, the more profitably the company can reinvest its earnings. The faster the company able to turn the reinvested earnings into profits, the faster its value increases from one year to another. And mind you, it is a big challenge to the management to consistently create value for every penny they spend. To prove this, not many stocks that has 15 per cent ROE consistently for the past 20 or 30 years, worldwide.

Stock Investing Advices #7: Buy at Discount Price

After the process of selection, now is the time to buy them! But of course make sure it is below the intrinsic value and you must have the margin safety of 80% discount from the calculated intrinsic value. Warren Buffet has to make sure he buys the stock at the lowest price possible. Have you heard the recent investment of Mr. Buffett on IBM and in these times of Euro and US Debt Crisis? In the same time, he has to be real that not to set very low price till he misses the golden opportunity. Even if the stocks are so profitable but the price is too high, he will just passes the opportunity to somebody else.

If you want to be as successful as Warren Buffet in stock investing, study each point thoroughly. Ignoring either one advice is enough to make you broke in stock market; simply because, in stock investing, due diligence counts.

Intentionally not following the advice proves that you are not ready for investing;perhaps you are just looking for fast cash.



http://www.investorluranski.com/2011/11/7-important-stock-investing-advices.html#more