Saturday, 21 March 2015

3 legs of Margin of Safety

Yes, this is the single most important thing you should know in investing.

ALWAYS buy with a margin of safety. Margin of safety issues are both qualitative and quantitative.

Let me show where I look for these margin of safety factors in my stock selection. There are 3 areas where one should look for margin of safety. Let's call these the 3 legs of Margin of Safety. Here they are.

1. QUALITY (Good to great quality growth stocks, with durable competitive advantage)

2. MANAGEMENT (Managers with integrity, intelligence and hardworking. Operational efficiency: Profit margin trends, ROE trends, and D/E trends that are good/great, maintained or improving)

3. VALUATION (Fair to bargain prices for Great companies, Big bargain prices for good companies.)

Well, choose your picks.

Yes, you can get great bargains too in foraging in gruesome companies that are selling at big bargain prices. Often, many of these remain gruesome and the prices may even continue to go down more due to fundamental deterioration in their businesses.

You have a build in margin of safety, IF you have the ability to pick good or great stocks that are selling at bargain or fair prices, especially when your investing horizon in holding these stocks are for the long term (>5 years). Warren Buffett teaches another margin of safety criteria of his own - that it is better to buy a great stock at fair price, than a fair stock at great price. Surely, he did not preach this without a basis.

If you dwell deeper into this statement, although many may look at this from the superior returns that the great stock offer over the good stock, though bought at perceived fair price (instead of bargain prices for a good stock), it is just another way of saying that the margin of safety for great stocks is better than for a good stock as you are more certain of the growth and earnings power of the great companies. This high probability of being right in projecting the earning power of the great companies is where the margin of safety lies.

In the gruesome company, they are termed gruesome because their earning power were non-existent, deteriorating or even un-predictable over the short or the long term.

I advise that if the companies you study fail in the QUALITY AND MANAGEMENT ISSUES, don't bother with the valuation. Keep the study and proceed no further with its valuation since we are only seeking to invest in stocks for the long term. There are so many other stocks to study for your LONG TERM portfolio. Your long term portfolio should only include the best quality stocks that are projected to deliver returns of > 15% or more per year (with reinvestment of the dividends).

When would you buy these stocks that have satisfied the quality and management issues (the first and second legs of the margin of safety) and that you have in your "to invest" list? Yes, you then look for a good price to buy, the third and last leg of margin of safety. This is when the price offered promises safety of capital (upside reward: downside risk of > 3:1) and a projected annualised return of > 15% per year.

Putting the 3 legs of margin of safety issues into perspective.

1. I am looking to populate or invite a company to join my esteem group of great companies in my portfolio for the LONG TERM.

2. I stress on 3 legs of margin of safety issues.

3. The first and second legs of my Margin of Safety issues look at QUALITY AND MANAGEMENT.

4. Why are they important? These qualities will allow me to predict their earning power, the most important thing that is going to deliver great returns to my portfolio.

5. The third or last leg of my Margin of Safety issues is also important. By buying at low prices, my upside: downside ratio is in my favour (I want at least >3:1, needs a lot of patience), thereby protecting my downside. A lower price gives me an additional return when the stock is revalued at its fair price.

6. One is investing for the long term, and often if the stock is a great stock with great earning power, you virtually need not have to sell. The total return after many years is mainly contributed by its earnings power, the great bargain price you bought into offer you an additional short term gain, which contributes a little only to the overall return over the long term, (though it was a big return over jthe short term.)

7. Stay focus on the long term.

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