Margin of Safety Benjamin Graham's grestest investment tool
Value Investing: Margin of Safety
Dr. Tejinder Singh Rawal
Chartered Accountant
tsrawal@tsrawal.com
A value investor always looks for stocks available at a throwaway price, thus buying at a “margin of safety”. This concept central to the discipline of value was pioneered by the father of value investing, Benjamin Graham. The concept has been so important for the Warren Buffett that he remarked, “The three most important words in investing are “margin of safety”, which means always building a 15,000 pound bridge if you’re going to be driving 10,000 pound trucks across it.”
Graham was the first person to realize that the basic truth about stock market investing is the price: you should pay considerably less that the real worth of share when you buy a share. The price of a share keeps hovering around its intrinsic value, at times the price would rise much higher than its value, and at times, the price would plummet to a ridiculously low figure. If the price falls, sooner or later the market is bound to realize that the share is a bargain, and this would bring the price close to its intrinsic value, sometimes the momentum, may take it further up. The real skill of an investor lies in finding the stocks that are selling much below their real worth, thus creating a “margin of safety” for the investor.
Graham would explain this concept in his lectures by telling the parable of a fictitious Mr. Market. Mr. Market is a whimsical character. He keeps approaching you everyday, and keeps quoting the prices of shares you own or intend to buy ( With the live quotations ticking on your computer screen, Mr. Market actually keeps quoting prices every moment). Even if the company may have a very stable business, unfortunately the quotations of Mr. Market are anything but stable. He has severe emotional problems; at times he becomes euphoric and can see only favourable factors affecting company. In that mood, he quotes a very high price. At times, his mood is very depressed, and he is pessimistic about the shares. He quotes a ridiculously low figure when in a bad mood, thinking that the sky is going to fall. The more manic-depressive his behaviour is, the better it is for you since you can find a great bargain.
One good thing about Mr. Market is that he does not mind being ignored. His job is to quote the prices, to buy or not to buy is purely your decision. If he shows up one day in a very foolish mood, you would do well to take advantage of him, but it could be disastrous for you if you succumb to his influence. In order to strike the right deal, you should be better in the art of valuation than Mr. Market. If you can’t understand the business better than Mr. Market, please don’t play the game. You should have the ability to know when he makes a stupid move and you should be able to capitalize on that.
“Margin of safety” being the difference between the price and the value, it gives you a cushion. With a high margin of safety, you pay, so to say, Rs. 50 for a 100 rupees note.
Buying in that situation heavily stacks the odds in your favour. On the other hand buying a stock without adequate margin of safety, or zero margin of safety exposes you to great risk, and makes your investment no better than a bet or a gamble. This would be so even if the company you have invested is a blue chip company. The underlying company would do well but the investor would still burn his fingers.
Graham always looked for companies which were so battered and neglected that they were sold even below their net working capital. He created a Net Current Asset Value (NCAV) model to find such bargains. Calculate the net working capital of the company, which is the excess of current assets over current liabilities. Subtract from this all the debts whether short term or long term. Divide the resultant figure by the number of issued shares of the company. If this per share value is less than the current market price of the share, you have a margin of safety. And, you are getting the whole of fixed assets free of cost. Graham looked for shares that offered at least 1/3rd margin of safety. While it may not be possible to find many shares meeting criteria of this high margin of safety, there are certainly some shares which pass through this screen. I often come across shares that meet these criteria and sometimes wonder why none else noticed it before.
A larger margin of safety also takes care of your judgmental errors, and the window-dressing by the companies. While it may not be possible to calculate the exact margin of safety, (if it were an exact science, investors would have already squeezed the shares dry of the entire margin) an intelligent approximation would do the job well. “To use a homely simile,” said Graham, “it is quite possible to decide by inspection that a woman is old enough to vote without knowing her age, or that a man is heavier than he should be without knowing his exact weight.”
A few caveats: First, even if you fancy on a particular share with a high margin of safety, don’t bet your whole fortune on it; it may be possible that you made an error of judgment, or that the market may fail to recognize the real worth of the share during the period you hold the share. The solution is diversification. Graham recommended ideally keeping 30 companies in your portfolio. This number could be less or more depending on how active an investor you are. Secondly, be patient. In the short term the stock price may dip even further. Third, when in doubt, stick to quality. Look for good quality management.
In conclusion, my advice to all serious investors is to read Graham and Dodd’s Security Analysis. If you were to read only one book on investment, this is the book. It ought to be read and re-read many times over during an investor’s lifetime. The low priced Indian edition, at Rs. 350 is the best investment you would have ever made.
Dr. Tejinder Singh RawalM.Com, MA( Economics and Public Administration), LLB, FCA, ISA, CISA, CISM, PhDChartered AccountantE 13, Anjuman Complex, Sadar,Nagpur 440 001 IndiaPh: +91 712 2582923 Fax +91 712 2583522Email: tsrawal@tsrawal.com
Dr. Tejinder Singh Rawal
Chartered Accountant
tsrawal@tsrawal.com
A value investor always looks for stocks available at a throwaway price, thus buying at a “margin of safety”. This concept central to the discipline of value was pioneered by the father of value investing, Benjamin Graham. The concept has been so important for the Warren Buffett that he remarked, “The three most important words in investing are “margin of safety”, which means always building a 15,000 pound bridge if you’re going to be driving 10,000 pound trucks across it.”
Graham was the first person to realize that the basic truth about stock market investing is the price: you should pay considerably less that the real worth of share when you buy a share. The price of a share keeps hovering around its intrinsic value, at times the price would rise much higher than its value, and at times, the price would plummet to a ridiculously low figure. If the price falls, sooner or later the market is bound to realize that the share is a bargain, and this would bring the price close to its intrinsic value, sometimes the momentum, may take it further up. The real skill of an investor lies in finding the stocks that are selling much below their real worth, thus creating a “margin of safety” for the investor.
Graham would explain this concept in his lectures by telling the parable of a fictitious Mr. Market. Mr. Market is a whimsical character. He keeps approaching you everyday, and keeps quoting the prices of shares you own or intend to buy ( With the live quotations ticking on your computer screen, Mr. Market actually keeps quoting prices every moment). Even if the company may have a very stable business, unfortunately the quotations of Mr. Market are anything but stable. He has severe emotional problems; at times he becomes euphoric and can see only favourable factors affecting company. In that mood, he quotes a very high price. At times, his mood is very depressed, and he is pessimistic about the shares. He quotes a ridiculously low figure when in a bad mood, thinking that the sky is going to fall. The more manic-depressive his behaviour is, the better it is for you since you can find a great bargain.
One good thing about Mr. Market is that he does not mind being ignored. His job is to quote the prices, to buy or not to buy is purely your decision. If he shows up one day in a very foolish mood, you would do well to take advantage of him, but it could be disastrous for you if you succumb to his influence. In order to strike the right deal, you should be better in the art of valuation than Mr. Market. If you can’t understand the business better than Mr. Market, please don’t play the game. You should have the ability to know when he makes a stupid move and you should be able to capitalize on that.
“Margin of safety” being the difference between the price and the value, it gives you a cushion. With a high margin of safety, you pay, so to say, Rs. 50 for a 100 rupees note.
Buying in that situation heavily stacks the odds in your favour. On the other hand buying a stock without adequate margin of safety, or zero margin of safety exposes you to great risk, and makes your investment no better than a bet or a gamble. This would be so even if the company you have invested is a blue chip company. The underlying company would do well but the investor would still burn his fingers.
Graham always looked for companies which were so battered and neglected that they were sold even below their net working capital. He created a Net Current Asset Value (NCAV) model to find such bargains. Calculate the net working capital of the company, which is the excess of current assets over current liabilities. Subtract from this all the debts whether short term or long term. Divide the resultant figure by the number of issued shares of the company. If this per share value is less than the current market price of the share, you have a margin of safety. And, you are getting the whole of fixed assets free of cost. Graham looked for shares that offered at least 1/3rd margin of safety. While it may not be possible to find many shares meeting criteria of this high margin of safety, there are certainly some shares which pass through this screen. I often come across shares that meet these criteria and sometimes wonder why none else noticed it before.
A larger margin of safety also takes care of your judgmental errors, and the window-dressing by the companies. While it may not be possible to calculate the exact margin of safety, (if it were an exact science, investors would have already squeezed the shares dry of the entire margin) an intelligent approximation would do the job well. “To use a homely simile,” said Graham, “it is quite possible to decide by inspection that a woman is old enough to vote without knowing her age, or that a man is heavier than he should be without knowing his exact weight.”
A few caveats: First, even if you fancy on a particular share with a high margin of safety, don’t bet your whole fortune on it; it may be possible that you made an error of judgment, or that the market may fail to recognize the real worth of the share during the period you hold the share. The solution is diversification. Graham recommended ideally keeping 30 companies in your portfolio. This number could be less or more depending on how active an investor you are. Secondly, be patient. In the short term the stock price may dip even further. Third, when in doubt, stick to quality. Look for good quality management.
In conclusion, my advice to all serious investors is to read Graham and Dodd’s Security Analysis. If you were to read only one book on investment, this is the book. It ought to be read and re-read many times over during an investor’s lifetime. The low priced Indian edition, at Rs. 350 is the best investment you would have ever made.
Dr. Tejinder Singh RawalM.Com, MA( Economics and Public Administration), LLB, FCA, ISA, CISA, CISM, PhDChartered AccountantE 13, Anjuman Complex, Sadar,Nagpur 440 001 IndiaPh: +91 712 2582923 Fax +91 712 2583522Email: tsrawal@tsrawal.com
posted by Dr. Tejinder Singh Rawal at 9:20 pm
0 Comments:
Post a Comment
<< Home