“Price is what you pay, value is what you get”
As an investor our aim is to buy low and sell high (ensuring profits) but most of us end up buying high (Believing that it can only go higher…Poof!) and selling at the bottom. Thus, the most important thing to remember is that valuation is an art and not a science! Hence, precisely valuing securities is bull crap.
John Keynes, an economist, said, “It is better to be roughly right than precisely wrong”. In our pursuit to buy underpriced securities our goal is to ascertain the approximate worth and not to be necessarily exact. This brings us to another problem. If I cannot value the exact price of the security how do I invest? (Don’t give me answers in Greek alphabets; I can’t understand them I am better equipped with my elementary math it gets the job done without confusions)
At what price to buy? That is when the concept of ‘Margin of Safety’ comes up. What is Margin of safety? It is the difference between your estimated price and current price of the security. When Investing we always want our margin of safety to be as high as possible. An analogy here is “if you have built a bridge which has maximum weight carrying capacity of 30K pounds only drive through 10-15 thousand pounds across it” that’s your margin of safety! It’s not necessary to precisely measure your load because you know that it is definitely way below 30K pounds!
Similarly buy securities which are so undervalued that you need not be precise with the intrinsic value of the security, there is a margin for error and because you have purchased the security well below the intrinsic value your risk considerably reduces.
This is what Ben Graham told to U.S Senate:
The Chairman: When you find a “Special situation” and you decide, just for illustration, that you can buy for 10 and it is worth 30, and you take a position, and then you cannot realize it until a lot of other people decide it is worth 30, how is that process brought about – by advertising or what happens?
Mr. Graham: That is one of the mysteries of our business, and it is a mystery to me as well as to everybody else. We know from experience that eventually the market catches up with value. It realizes it one way or another.
What Graham tells us is that all we have to do is try and buy securities at deep discount and have enough margin of safety so that eventually when the markets catch up with the security we get our returns.
“Even with a margin [of safety] in the investor’s favor, an individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss – not that loss is impossible. But as the number of such commitments is increased the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses.”
Thus this disclaimer by Graham clearly saying that this is not a sure fire way of profits but over the long run there will be positive returns.
“The market, like the Lord, helps those who help themselves. But, unlike the lord, the market does not forgive those who know not what they do.” – Warren Buffett
Ignorance is not bliss when you are investing! It’s dangerous when you are ignorantly investing with your money and can get disastrous if you are handling other people’s money!
How do you ensure that you are buying with a margin of safety??
These are a few pointers which an investor could use to determine if he has enough Margin of safety in his investment. (This by no means is an exhaustive list!)
Comparing your Shares / stock with respect to Bonds
Invest when the Earnings/Price (Invert P/E ratio, it gives the yield on investment) is greater than the Present AA bond yield. (Note: The value of Earnings in the ratio is preferably average of few years to ensure that data is not skewed)
Example: A company having a P/E (average) of 8 will give E/P value of 12.5% (adjusted for pre tax: 12.5/ (1-0.30) assuming 30% tax rate is 17.8%) and if the AA bond yield is 12% pre tax. You have a margin of safety of 30%+ on your investment when compared to a bond!
Comparing your estimated return from the security with your expected return (say if your minimum expected rate of return from investments is 15% i.e. your hurdle rate, and then you invest only when there is a security available at a price that offers more than 15% returns)
Finally, “To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks.” – Benjamin Graham
References: The Intelligent Investor – Benjamin Graham