Friday, 20 January 2012

Margin of Safety Concept in Growth Stocks

The philosophy of investment in growth stocks parallels in part and in part contravenes the margin-of-safety principle.
  • The growth-stock buyer relies on an expected earning power that is greater than the average shown in the past.
  • Thus he may be said to substitute these expected earnings for the past record in calculating his margin of safety.
  • In investment theory there is no reason why carefully estimated future earnings should be a less reliable guide than the bare record of the past; in fact, security analysis is coming more and more to prefer a competently executed evaluation of the future.
  • Thus the growth-stock approach may supply as dependable a margin of safety as is found in the ordinary investment— provided the calculation of the future is conservatively made, and provided it shows a satisfactory margin in relation to the price paid.

The danger in a growth-stock program lies precisely here.
  • For such favored issues the market has a tendency to set prices that will not be adequately protected by a conservative projection of future earnings.
  • (It is a basic rule of prudent investment that all estimates, when they differ from past performance, must err at least slightly on the side of understatement.)

The margin of safety is always dependent on the price paid.
  • It will be large at one price, small at some higher price, nonexistent at some still higher price.
  • If, as we suggest, the average market level of most growth stocks is too high to provide an adequate margin of safety for the buyer, then a simple technique of diversified buying in this field may not work out satisfactorily.  
  • special degree of foresight and judgment will be needed, in order that wise individual selections may overcome the hazards inherent in the customary market level of such issues as a whole.

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