'What the Value investors are looking for is Margin of Safety. They are looking at buying a stock at as much of a discount to Intrinsic value as possible. This provides them with a Margin of Safety because the future is always difficult to predict!'
That is what we said in our piece on Value Investing. If you have not read it, we suggest that you may want to do so before reading this story.
It is clear enough from the above statement that when you buy something at a discount to its Intrinsic value then you enjoy a degree of safety in relation to that investment.
The Value Investor aims to buy a genuine Rs500 note (not the fake variety) for Rs200. He is equally willing to buy it for Rs300 or Rs400. But as the price climbs and gets up to Rs499.99 he turns cautious. The reason for his behavior is quite simple. As the price climbs closer to Rs500 the Margin of Safety is eroded.
But that should be obvious enough to all of you.
As for the issue of calculation of Intrinsic value there are several methods that you could adopt - Liquidation value, Replacement value Book value or even Dividend Discount Model (Discounted cash flow). The choice of method depends on what you believe is most relevant to the stock you want to evaluate.
But what of the intangibles?
However as we move away from the mechanical and quantifiable to the metaphysical and the world of ideas, it is far more difficult to establish Intrinsic value. For a company like ACC we could choose very easily to go with Replacement value as the best estimate of Intrinsic value. That is not very difficult to calculate. But how do you estimate Intrinsic value of companies such as Infosys and HLL? Obviously the traditional Balance Sheet based measures do not help you arrive at a benchmark.
These companies take their value from many an intangible asset, which makes the simple Replacement value or Book value based estimates meaningless.
There is no option but to value them as a 'Going Concern' - based on their future profits (Earning streams). In other words you have to turn to models based on Discounted cash flow. But that is no easy task.
Several imponderables underpin a forecast
It involves projecting the company's profits for many years into the future. It requires making an assumption about that rate at which the company will grow. And underlying that single assumption are several assumptions about how the market for the company's products will evolve, whether their management will continue to be as focused as you currently believe them to be, how competitors will behave or respond, what regulators might or might not do in reshaping the competitive environment and technological obsolescence.
In reality there are hundreds of imponderables underlying that one simple growth estimate. The Margin of Safety is meant protect you against those imponderables.
But the Margin of Safety is also meant to protect you against one other error. In the words on Benjamin Graham:
While it is true that it is the expected future earnings and not the past that determines value, it is also true that there tends to be a rough relationship or continuing connection between past earnings and future earnings. In the typical case, therefore, it is worthwhile for the analyst to pay a great deal of attention to the past earnings, as the beginning of his work, and to go on from those past earnings to such adjustments for the future as are indicated by his further study.
You cannot properly buy an investment security on the basis of expected earnings, where these are very different from past earnings -- and where you are relying on new developments, as it were, to make the security sound, when it would not have been sound on the basis of the past.
But you may say, conversely, that if you buy it on the basis of the past and the new developments turn out to be disappointing, you are running the risk of having made an unwise investment. We find from experience, though, that where the past Margin of Safety that you demand for your security is high enough, in practically every such case the future will measure one. This type of investment will not require any great gifts of prophesy, any great shrewdness with regard to anticipating the future.
In other words the basic Principle underlying the Margin of Safety is one of 'Continuity'.
In the words of Graham:
It is also true that there tends to be a rough relationship or continuing connection between past earnings and future earnings.
We are not suggesting that you drive with your eyes fixed on the rear view mirror. What we are however saying is that what you see in your rear view mirror holds the key to what you will see (in front of you) through the front windshield of the car.
Going rosy-eyed
When you project the earnings that the company is likely to earn over the next 10 years in an attempt to arrive at an Intrinsic value, you would do well to remember that. Many an investment mistake can be attributed to projecting a rosy-eyed view of the future for a company whose past never justified such a forecast.
But first a word of caution about looking at the past. The past is not just the year gone by. The past is a normalized and reasonably long period of time over which a trend can be discerned. Say 5 years. In other words look at what Tisco's profit growth over a 5-year period has been when estimating its future growth rather than just the last 2 quarters - in which its profits have grown by over 100%.
| Margin of Safety |
Why Margin of Safety?
There are 2 types of mistakes an Investor can make - buying a bad stock and buying a good stock at the wrong price. Nothing other than rigorous analysis and discipline can prevent the first mistake. But there is a method to prevent the second mistake. The Margin of Safety.
According to Graham there are 2 methods of analysis and investing, which emphasize value.
The first division represents buying into the market as a whole at low levels; and that, of course, is a copybook procedure. Everybody knows that is theoretically the right thing to do. It requires no explanation or defense; though there must be some catch to it, because so few people seem to do it continuously and successfully.
The second method emphasizes the concept of Margin of Safety and underpins Value Investing:
The thing that you would naturally be led into, if you are value-minded, would be the purchase of individual securities that are undervalued at all stages of the security market. That can be done successfully, and should be done -- with one proviso, which is that it is not wise to buy undervalued securities when the general market seems very high. Don't forget that if Mandel or some similar company sells at less than your idea of value, it sells so because it is not popular; and it is not going to get more popular during periods when the market as a whole is declining considerably. Its popularity tends to decrease along with the popularity of stocks generally.
Next time you buy a stock, don't stop at asking yourself if you are buying a good stock. Also ask the question - Am I buying a good stock at the wrong price?
If you enjoy a Margin of Safety on your purchase then it is likely that you are buying at the right price.
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