|Paying Up Doesn't Pay Off|
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Wednesday, 17 April 2013
Margin of Safety. Paying Up Doesn't Pay Off
The above chart contains seven of the best businesses in existence.
In the five years from 1999 to 2004, these wonders of American business boosted their earnings per share by an average of 81%, yet had you invested in all of them in 1999, your aggregate return would have been a disappointing negative 35%.
The cause of your loss would be the high price you paid for these businesses in 1999 when their price/earnings ratio averaged a breathtaking 67 times.
By 2004, the average price/earnings ratio had returned to a more rational 22 times, more than offsetting the spectacular gains in earnings per share posted by these corporate giants.
An intelligent investor would have recognized that even for the greatest businesses in the world, at 67 times earnings, Mr. Market was asking too high a price and no margin of safety was available.
MARGIN OF SAFETY
If you had asked Graham to distill the secret of sound investing into three words, he might have replied, "margin of safety/" These are still the right three words and will remain so for as long as humans are unable to accurately predict the future.
As Graham repeatedly warned, any estimate of intrinsic value is based on numerous assumptions about the future, which are unlikely to be completely accurate. By allowing yourself a margin of safety - paying only $60 for a stock you think is worth $100, for example - you provide for errors in your forecasts and unforeseeable events that may alter the business landscape.
Just think, if you were asked to build a bridge over which 10,000 pound trucks were to pass, would you build it to hold exactly 10,000 pounds. Of course not - you'd build the bridge to hold 15,000 or 20,000 pounds. That is your margin of safety.