Friday, 20 January 2012

Margin of Safety in Good-Quality and Low-Quality Stocks

However, the risk of paying too high a price for good-quality stocks—while a real one—is not the chief hazard confronting the average buyer of securities.

Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.
  • The purchasers view the current good earnings as equivalent to “earning power*” and assume that prosperity is synonymous with safety.
  • It is in those years that bonds and preferred stocks of inferior grade can be sold to the public at a price around par, because they carry a little higher income return or a deceptively attractive conversion privilege.
  • It is then, also, that common stocks of obscure companies can be floated at prices far above the tangible investment, on the strength of two or three years of excellent growth.
  • These securities do not offer an adequate margin of safety in any admissible sense of the term.
  • Coverage of interest charges and preferred dividends must be tested over a number of years, including preferably a period of subnormal business such as in 1970–71.
  • The same is ordinarily true of common-stock earnings if they are to qualify as indicators of earning power.
  • Thus it follows that most of the fair-weather investments, acquired at fair-weather prices, are destined to suffer disturbing price declines when the horizon clouds over—and often sooner than that.
  • Nor can the investor count with confidence on an eventual recovery—although this does come about in some proportion of the cases—for he has never had a real safety margin to tide him through adversity.

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