Tuesday, March 03, 2009

More on margin of safety

A frequently asked question on value investing is this: how can you be so sure that the co's intrinsic value is $100 (or any other no.)?

For those not so sure what the hell is going on, read these first
Value Investing
Intrinsic Value
Good Investment

Well, the truth is, you are never sure, you can spend 20 days calculating the intrinsic value of the company and become so sure that the stock is undervalued. So you buy and the stock tank 20%. Shiok huh?

Intrinsic value goes hand in hand with margin of safety. Bcos you can never be sure whether you really got the intrinsic value right, you need to have a margin of safety. ie you will only buy the stock if the current price is way, way, WAY below your calculated intrinsic value. As a rule of thumb, I recommend 30-40% below your calculated intrinsic value. That is if you calculated that a stock is worth $100, you should be buying only when it hits $60-70.

Buffett used the example of building a bridge. If you know that the maximum weight of vehicles that will cross the bridge is 10 tons (based on historical statistics), will you build a bridge that will support 10 tons or a bridge that will support 30 tons?

That is margin of safety.

Ben Graham, the grandfather of value investing once said this: if you need to surmise value investing into only 3 words, it would be "margin of safety". It is THAT important.

Unfortunately, most investors don't really have this concept in mind. Even those who are very experienced. I guess it's not easy partly bcos have a strict margin of safety rule forces you to pass on many investment ideas even if they are quite good. And when you see them rally 100% after you decided NOT to buy them, wah shiok right? Now every wall you see has a purpose. For you to bang your head hard on it! Haha!

But having a margin of safety will make very sure that you will not lose your shirt. Even if you are damn wrong on your intrinsic value, you may lose a bit of money, the stock may tank 20%, below your buying price but quite unlikely to tank 80% below your buying price. And chances are after it tanked it will creep back up again, it will not bankrupt you. That's the strength if you have a huge margin of safety.

1 comment:

  1. Hi 8 %,
    Margin of Safety

    I have only a trade-school education.

    But I tell myself I have to learn about stock investment because I always admire successful business entrepreneurs.

    So I borrow all the type of books on investment and finance management (from the library) which are written especially for lowly educated people like me.

    Till this day, I still do.

    After reading many books, I am encouraged by some famous quotations or practices of the world greatest stock market investors.

    John Templeton:
    "He buys only in a stock market when there is blood running on the street."

    Warren Buffet:
    "Temperament is more important than high IQ."

    So Warren Buffet has enlightened, emboldened and confirmed for me even a lowly educated person like me can learn to invest in the stock market.

    As for John Templeton, He has disciplined me to buy only when there is blood running on the street.

    The obvious main reason is at this time, I can buy many stocks of different sectors at quite high or good "Margin of Safety"

    To tell the truth, till this day I still don't know how to calculate the "margin of safety' of a stock.
    But do you think I can recognize one when I see it?

    I blog here to encourage all "lowly educated people" not to give up in life. Discover your 'interest' and go for it man!

    Lowly Educated