THE BIG PICTURE. Investing is less about the stock price and more about the value of the business.

The Big Picture

Finding companies you know is only the beginning; the circle of competence is only meant to help you stay within your arena of expertise. 

Once you have generated a list of the companies you understand, the next step should be conducting an analysis of the financials. 

Don’t worry — you don’t have to be a finance whiz to understand the basics of the stock market. 

For example, Berkshire Hathaway’s investment philosophy is surprisingly simple: The company should have 
1.  consistent earning power, 
2.  good return on equity, 
3.  capable management and 
4.  be sensibly priced. 


Investing is less about the stock price and more about the value of the business — is it a good one?

Successful investing is more about learning over time and slowly expanding your circle of competence. For now, stick with what you know and focus on the long term. 

Anyone can find success in the stock market; you just have to keep it simple. 

As Buffett has famously said, “You don’t need to be a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ.” And you know what? $60 billion says he’s right.

Take On Risk With A Margin of Safety

When investing, it is well accepted that one of the main things you should focus on is risk. However, modern investment theory mainly focuses on the volatility of an asset in its treatment of risk. The margin of safety theory is a little different - it argues that downward spikes of volatility make stocks less risky. This is an important concept to grasp in depth, because common risk theories can lead to missed opportunities. Investing gurus Benjamin Graham and Warren Buffett were instrumental in developing margin of safety. Read on to find out how this theory helped propel their portfolios to meteoric heights.

SEE: Beta: Gauging Price Fluctuations

Beta's Misgivings

In general, people do not like surprises. More precisely, people do not like adverse surprises. Because investors are assumed to be more averse to losing money than gaining it, modern investment theory views the volatility of an asset, as measured by its beta, as the main component of risk. The theory implies that investors should pay less for an asset with a higher beta.

One problem with beta is that it implies that if an asset's value suddenly drops, even due to irrational market behavior, that it becomes more risky because it will have a higher beta. We'll poke some holes in this view in moment, using an example from Warren Buffett.

An Alternate Strategy of Risk

Introduced by the father of value investing, Benjamin Graham, and notably implemented by Warren Buffett, margin of safety was presented as a different view of risk and how to protect against it. Graham's concept is not new. He first presented his investing style with David Dodd in 1934's "Security Analysis" and later with his more accessible book, "The Intelligent Investor", which was first published in 1949.

SEE: The Intelligent Investor: Benjamin Graham

Graham characterized volatility as "Mr. Market" coming each day to buy from you or sell to you. Graham hoped to buy assets that Mr. Market would sell to him with a 50% margin of safety. This, essentially, would be like trying to buy a dollar for $0.50.

Graham discussed how companies all have an intrinsic measurable value. When Graham first pitched and practiced this idea, information on companies was not nearly as easy to access. He would search through the financial statements and look for what he called net-nets, or companies trading below their liquidation values.

Graham would take a company's current assets with considerable deductions, and subtract all of the liabilities on the balance sheet. At its heart, Graham's net-net investing is the most conservative value approach, and involves very little risk if done right.

SEE: 12 Things You Need To Know About Financial Statements

Example - Finding A Company\'s Net-Net ABC Company has the following balance sheet and market capitalization: Cash $250 Cash Equivalents $50 Accounts Receivable (A/R) $100 Inventories $100 Total Liabilities $300 Share Price $62.50

Cash and cash equivalents are good to go, we have $300 there. Next, we turn to A/R, some of which will not be paid. Usually we have a net A/R number on the balance sheet, indicating the amount of receivables the company expects to recover. If we have it, this net number is based on the company's history of collecting receivables, and is a good indicator, but we would still discount it a little for added safety.

In this scenario, we have a gross A/R number. Again we don't expect to recover it all, but ABC is known to have a fairly reliable client base and we could easily anticipate recovering around 80% of A/R - to be even more conservative we will only factor in recovering 75%. Many investors may want to take a look at the company's allowance for doubtful accounts in their financial statements as a method for gauging an accurate recovery percentage, but in this case, we'll value A/R at $75 ($100 x 0.75). Finally, there is ABC's inventory. ABC has competitors, which we could assume, at the very least, would buy the inventory for half its value. So we take the inventory's value at $50 ($100 x 0.5).

SEE: Volatility's Impact On Market Returns

We end up with marked down current assets of $425 ($300 + $75 + $50), and total liabilities of $300. This net-net is worth $125 ($425 - $300), not even accounting for any real estate or other long-term assets the company might have. With the company selling at only $62.50 in the market, this is a net-net with a 50% margin of safety. Paying half of a company's net-net value was Graham's goal, and at most, he would pay two-thirds of a company's net-net value, for a 33% margin of safety. In our example, we have a 50% buffer between the market value of the company and our conservative valuation of the company's current assets. By only buying at a steep discount to our valuation, this margin of safety provides its own built-in measure against the risk of mistakes in our calculations.

Let Volatility Be Your Friend

This process of investing did not guarantee success, but with research and hard work, finding one of these scenarios was about as close to a sure thing as you could get. A lot has changed, and Graham's net-nets have essentially disappeared in the modern market. With the quick and widespread dissemination of information, markets have become somewhat more efficient.

While net-nets are disappearing, investors can see that the market provides sales on assets quite often. The concept of buying companies with an adequate margin of safety still remains, and has been practiced with great success by many value investors, most notably Warren Buffett.

Example - Taking the Value of Long-Term Assets Into Account In the ABC example, we gave absolutely no value to the company\'s long term assets. Let\'s return to the example and suppose that that the company\'s share price is now at $200. We calculated its net-net worth at $125, so according to that it would not be a good value, but we note that ABC also has the following assets on its books: Plant, Property, & Equipment $200 Long-Term Bonds $100

We notice from some research that the plants on the company's balance sheet have likely appreciated because property values have gone up in that area. However, we will remain very conservative in this example and still value it at $200. Next, with the company's long-term bonds, we may worry about the market value if the bonds need to be sold quickly. We will only accept 75% of the value, and value the bonds at $75 ($100 x 0.75). We end up with an asset value of $400 (net-net worth of $125 + $200 + $75). Again, we can buy the stock of this company with a 50% margin of safety at its current market price of $200.

This again seems like a home run of an investment. We are still being conservative, and we ignored any assets that could be off ABC's books, such as the appreciated value of its real estate. Other hidden assets are brands, exceptional management, competitive advantages, etc. There is much to be said about the market value of hidden assets, but the point will remain the same.

Don't Run From Beta

Now looking strictly at beta, let's say ABC had a beta of 1.5. After all of our work, we decide to go to bed and buy tomorrow. However, the next day, "Mr. Market" decides to take the price of ABC down to $150, while the rest of the market stays pretty flat. This sharp 25% decline in ABC stock makes it riskier according to beta.

However, according to Warren Buffett in his 1993 letter to shareholders this altered perception of risk is misleading:

"Under beta-based theory, a stock that has dropped very sharply compared to the market - as had Washington Post when we bought it in 1973 - becomes "riskier" at the lower price than it was at the higher price. Would that description have then made any sense to someone who was offered the entire company at a vastly-reduced price?"

What this means is that volatility is our friend in this scenario. We did the work to value the company, and now Mr. Market is just offering it to us at a steeper discount and a higher margin of safety. If we had already made the purchase before the decline, we might kick ourselves for bad timing, but according to our research, an investment in ABC is still worth much more than what we paid.

SEE: Beta: Knowing The Risk

Take a Page From the Masters

The concept of margin of safety as practiced by Warren Buffett is not that complicated. These are fairly simple ideas, and should teach us all not to rely simply on volatility as a judge of risk. Many common theories of risk make volatility out to be a bad thing, and if a stock's sea becomes choppy, some investors may sail for calmer waters. But take a cue from Warren Buffett. He, and other value investors, get excited in volatile and down markets. If you invest carefully, and with an adequate margin of safety, Mr. Market's mood swings can lead to great opportunities.

Follow Warren Buffet’s Road to Riches

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http://www.investopedia.com/articles/financial-theory/08/margin-of-safety.asp?rp=i&utm_source=coattail-buffett&utm_medium=Email&utm_campaign=WBW-3/26/2015

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.

Practical suggestions on switching stocks

Let us summarize our practical suggestions in the matter of security switches as follows:

The investor who begins with a list of standard, first-grade common stocks can expect some of them to lose quality through the years.

His aim should be to replace these, with a minimum sacrifice of dividend return and with a fair chance of recouping any loss of principal value resulting from their sale.

The best means of accomplishing this is by seeking out attractive issues in the secondary group.  A competent security analyst is usually in a position to recommend a number of such issues which by objective tests appear to be worth substantially above their selling price.  

The fundamental principle of every security replacement should be the following:
Each dollar paid for the issue bought should appear to obtain more intrinsic value than was represented by a dollar's worth of the issue sold.

We believe, in sum, that quality may be approached soundly by way of value.  If the value is abundant, the quality may be deemed sufficient.


Benjamin Graham

Most valuations (even good ones) are wrong

Now this can be shocking to you if you spend a lot of time arriving at that magical number (intrinsic value) that helps you ascertain whether you must buy a stock or not.

Damodaran talks about three kinds of errors that cause most valuations – even the ones “meticulously” calculated – to go wrong:

1. Estimation error…that occurs while converting raw information into forecasts.
2. Firm-specific uncertainty…as the firm may do much better or worse than you expected it to perform, resulting in earnings and cash flows to be quite different from your estimates.
3. Macro uncertainty…which can be a result of drastic shifts in the macro-economic conditions that can also impact your company.

The year 2008 is one classic example when most valuations – even the good ones – went horribly wrong owing to the last two factors – firm-specific and macro uncertainties.

As Damodaran writes…

While precision is a good measure of process in mathematics or physics, it is a poor measure of quality in valuation.

So, to value or not value?
Knowing that your valuation could be wrong (and in most cases, it would be) despite any kind of precision you employ in your calculations, it should not lead you to a refusal to value a business at all.

This makes no sense, since everyone else looking at the business faces the same uncertainty.

Instead what you must do to increase the probability of getting your valuations right is…

1. Stay within your circle of competence and study businesses you understand. Simply exclude everything that you can’t understand in 30 minutes.
2. Write down your initial view on the business – what you like and not like about it – even before you start your analysis. This should help you in dealing with the “I love this company” bias.
3. Run your analysis through your investment checklist. A checklist saves life…during surgery and in investing.
4. Avoid “analysis paralysis”. If you are looking for a lot of reasons to support your argument for the company, you are anyways suffering from the bias mentioned above.
5. Calculate your intrinsic values using simple models, and avoid using too many input variables. In fact, use the simplest model that you can while valuing a stock. If you can value a stock with three inputs, don’t use five. Remember, less is more.
6. Use the most important concept in value investing – ‘margin of safety’. Without this, any valuation calculation you perform will be useless.

At the end of it, Damodaran writes…

Will you be wrong sometimes? Of course, but so will everyone else. Success in investing comes not from being right but from being wrong less often than everyone else.

So don’t justify the purchase of a company just because it fits your valuation. Don’t fool yourself into believing that every cheap stock will yield good returns. A bad company is a bad investment no matter what price it is.

Charlie Munger explains that – “a piece of turd in a bowl of raisins is still a piece of turd”…and…“there is no greater fool than yourself, and you are the easiest person to fool.”

So, get going on valuing stocks…but when you find that the business is bad, exercise your options.

Not a call or a put option, but a “No” option.

Have you ever avoided buying a stock you “loved” because its valuations were not right? 

http://www.safalniveshak.com/avoid-2-bitter-truths-of-stock-valuations/

2 Bitter Truths of Stock Valuation

1. All valuations are biased

2. Most valuations (even good ones) are wrong

How to find “conservative” investments? The ones with the greatest probability of preserving your purchasing power and with the least amount of risk.

Buffett resisted buying large and popular companies because he thought this category was valued irrationally by investors. But then, he was not in favour of buying small, unproven companies as well. As he wrote in his 2010 letter…

At Berkshire, we make no attempt to pick the few winners that will emerge from an ocean of unproven enterprises. We’re not smart enough to do that, and we know it.

Instead, we try to apply Aesop’s 2,600-year-old equation to opportunities in which we have reasonable confidence as to how many birds are in the bush and when they will emerge (a formulation that my grandsons would probably update to “A girl in a convertible is worth five in the phonebook.”).

Obviously, we can never precisely predict the timing of cash flows in and out of a business or their exact amount. We try, therefore, to keep our estimates conservative and to focus on industries where business surprises are unlikely to wreak havoc on owners.

Even so, we make many mistakes: I’m the fellow, remember, who thought he understood the future economics of trading stamps, textiles, shoes and second-tier department stores.

This reiterates Buffett’s key definition of conservatism over these years – conservatism depends on how you choose and not what you choose.

In other words, investing conservatively is not about simply identifying large well-known businesses, but going through a process that identifies why a particular company qualifies as a conservative investment.

As Buffett would want you to understand, there is one simple way to look at a conservative investment.

Conservative investment = Preservation of capital

A conservative investment is one that has the greatest probability of preserving your purchasing power and with the least amount of risk.

This probability can in turn arise from the process that you follow to identify such opportunities that will preserve your purchasing power in the future.

So, where most investors fail in attempting to invest “conservatively” is blindly assuming that by purchasing any security that qualifies as a conservative investment, they are in fact, conservative investors.

In other words, such investors are thinking conservatively, but not acting conservatively.

If you indulge in such things, it could prove to be a costly affair.

Here is what Buffett wrote in 1965…

Truly conservative actions arise from intelligent hypotheses, correct facts and sound reasoning. These qualities may lead to conventional acts, but there have been many times when they have led to unorthodoxy. In some corner of the world they are probably still holding regular meetings of the Flat Earth Society.

We derive no comfort because important people, vocal people, or great numbers of people agree with us. Nor do we derive comfort if they don’t. A public opinion poll is no substitute for thought. When we really sit back with a smile on our face is when we run into a situation we can understand, where the facts are ascertainable and clear, and the course of action obvious. In that case – whether other conventional or unconventional – whether others agree or disagree – we feel – we are progressing in a conservative manner.

The above may seem highly subjective. It is. You should prefer an objective approach to the question. I do. My suggestion as to one rational way to evaluate the conservativeness of past policies is to study performance in declining markets.

http://www.safalniveshak.com/wit-wisdom-warren-part5/

A true value investor is likely to perform better in a bear market than in a bull market.

Patience is a virtue for value investors

The last part of Buffett’s 1957 letter carries a very important lesson in patience for value investor. Here is what he wrote…

To some extent our better than average performance in 1957 was due to the fact that it was a generally poor year for most stocks. Our performance, relatively, is likely to be better in a bear market than in a bull market so that deductions made from the above results should be tempered by the fact that it was the type of year when we should have done relatively well. In a year when the general market had a substantial advance I would be well satisfied to match the advance of the Averages.

Despite calling ourselves “value investors”, a lot of us lose patience when stock prices are falling and get elated when they are rising.

But as Buffett wrote, a true value investor is likely to perform better in a bear market than in a bull market.

This is simply because when you are value investor, you buy good quality stocks and that too only at reasonable margin of safety (around 30-50%).

So when stock prices fall in a bear market, your good quality stocks bought at reasonable margin of safety may earn you lesser losses than the broader markets.

On the other hand, in a bull market, when even garbage is considered a dessert, and people are lapping up everything that’s rising in price, Mr. Market usually ignores good quality “boring” businesses which you hold in your portfolio…

…and thus you must be happy to earn just as much as the broader markets. That’s when you must not try to ride the bull but instead tell those riding it – “I’ll see you in the next bear market!”

This wouldn’t be arrogance on your part. This would be sensibility, as Buffett has proved over the past six decades.

http://www.safalniveshak.com/wit-wisdom-warren-part1/

Margin of safety: from basic tenet to most of the strategy

Main points:

1.  Investors should not target a rate of return, but rather make the goal simply one of acquiring undervalued assets.

2.  Klarman suggests always moving on to new assets so as to always hold the most undervalued securities available. No investment is considered sacred when a better one comes along.

3.  Valuation should always be performed conservatively, giving considerable weight to worst-case liquidation value as well as to other methods.

4.   Investors must be aware that the world can change unexpectedly and sometimes dramatically; the future may be very different from the present or recent past. Investors must be prepared for any eventuality.  

5.  Buying with an optimal margin of safety should be your primary, and in some sense your only, investment goal.  

6.  Most investment approaches do not focus on loss avoidance or on an assessment of the real risks of an investment compared with its return. Only one that I know does: value investing.

8 Nov 2011 by Jim Fickett.

While all value investors claim “buy below true worth” as a basic principle, Klarman turns this into most of a strategy. For example, he advocates always holding the most undervalued assets, even if this means selling other things “too soon”. And he makes the intriguing proposal that one should not target a rate of return, but rather make the goal simply one of acquiring undervalued assets.

As illustrated in the recent post Margin of safety, the idea of buying well below true worth is fundamental to value investing as implemented by a number of famous practitioners. Klarman, however, takes this principle to a new level. Whereas Grantham discussed waiting until full value was realized before selling, and Buffett buys companies to hold them forever, Klarman suggests always moving on to new assets so as to always hold the most undervalued securities available:

Value investors continually compare potential new investments with their current holdings in order to ensure that they own only the most undervalued opportunities available. Investors should never be afraid to reexamine current holdings as new opportunities appear, even if that means realizing losses on the sale of current holdings. In other words, no investment should be considered sacred when a better one comes along.

He admits that buying with the best possible margin of safety is a challenge:

If you cannot be certain of value, after all, then how can you be certain that you are buying at a discount? The truth is that you cannot. …

Should investors worry about the possibility that business value may decline? Absolutely. … First, since investors cannot predict when values will rise or fall, valuation should always be performed conservatively, giving considerable weight to worst-case liquidation value as well as to other methods. …

Value investing is simple to understand but difficult to implement. Value investors are not supersophisticated analytical wizards who create and apply intricate computer models to find attractive opportunities or assess underlying value. The hard part is discipline, patience, and judgment. Investors need discipline to avoid the many unattractive pitches that are thrown, patience to wait for the right pitch, and judgment to know when it is time to swing.

Nevertheless, he suggests that buying with an optimal margin of safety should be your primary, and in some sense your only, investment goal:

One of the recurrent themes of this book is that the future is unpredictable. No one knows whether the economy will shrink or grow (or how fast), what the rate of inflation will be, and whether interest rates and share prices will rise or fall. Investors intent on avoiding loss consequently must position themselves to survive and even prosper under any circumstances. Bad luck can befall you; mistakes happen. The river may overflow its banks only once or twice in a century, but you still buy flood insurance on your house each year. Similarly we may only have one or two economic depressions or financial panics in a century and hyperinflation may never ruin the U.S. economy, but the prudent, farsighted investor manages his or her portfolio with the knowledge that financial catastrophes can and do occur. Investors must be willing to forego some near-term return, if necessary, as an insurance premium against unexpected and unpredictable adversity.

Choosing to avoid loss is not a complete investment strategy; it says nothing about what to buy and sell, about which risks are acceptable and which are not. A loss-avoidance strategy does not mean that investors should hold all or even half of their portfolios in U.S. Treasury bills or own sizable caches of gold bullion. Rather, investors must be aware that the world can change unexpectedly and sometimes dramatically; the future may be very different from the present or recent past. Investors must be prepared for any eventuality.

Many investors mistakenly establish an investment goal of achieving a specific rate of return. …

Rather than targeting a desired rate of return, even an eminently reasonable one, investors should target risk. Treasury bills are the closest thing to a riskless investment; hence the interest rate on Treasury bills is considered the risk-free rate. Since investors always have the option of holding all of their money in T-bills, investments that involve risk should only be made if they hold the promise of considerably higher returns than those available without risk. This does not express an investment preference for T-bills; to the contrary, you would rather be fully invested in superior alternatives. But alternatives with some risk attached are superior only if the return more than fully compensates for the risk.

Most investment approaches do not focus on loss avoidance or on an assessment of the real risks of an investment compared with its return. Only one that I know does: value investing.

Klarmsn's success is a strong argument for these views. But each person has to find his own way, and there are two areas where I have a hard time reconciling this strategy with my own view of the world.

http://www.clearonmoney.com/dw/doku.php?id=investment:commentary:2011:11:08-margin_of_safety_from_basic_tenet_to_most_of_the_strategy

The LONGER a stock remains seriously UNDERVALUED and the LONGER they DONT' RETURN TO NORMAL VALUE, the BETTER it is for the investor

A Margin of Safety BOOSTS Returns Rather than Just Providing Protection


The longer the stock remains undervalued, the better it is for shareholders, because their reinvested dividends, or their new purchases, or management’s share buybacks, continue to accumulate undervalued shares.    

It actually becomes a demonstrably negative scenario for a long term investor when their stocks go up above fair value.    


That’s how Buffett made 30-50% returns in his early days. 

He wasn’t investing in companies that were growing earnings by 30-50% per year; he was investing in companies that were seriously undervalued.

Eventually, those stocks will return to normal values, and the longer they don’t, the better it is for the investor.    



Comments:  
A most important point.
As a value investor, you should be happy for the stock market to be down.
It is only then, you can find the bargains you wish.
As you will be a net investor in stocks for the future and for the long term, you should welcome a down market, so that you can buy stocks at bargain prices.
Yet, in many forums, everyone is cheering for the prices of stocks to rise. 

Notes from Seth Klarman's Margin of Safety

Notes_To_Margin_of_Safety

How to use a Margin of Safety when Investing

A fundamental part of value investing is to ensure that there is a margin of safety with your investments.

What this means is that you buy a stock when its price is not only lower than or equal to your calculated fair price, but that it’s significantly lower. This provides you with some gray area where your assumptions about the company can be a little bit off, and yet the investment will still turn out okay over the long run.

The margin of safety means that your assumptions would have to be significantly off course for that investment not to work out. But even then, by diversifying across 20+ companies and into other asset classes, the scenario becomes statistical in nature. For example, if you invest in 20 companies, and you only invest when a stock is trading at least 15% below your calculated fair price, then one or two of them can go bad while your overall portfolio will still perform admirably.

In the example of this chart, the time to buy would be when the stock price (red line) falls below the intrinsic fair value (blue line). It’s easier said than done, because you won’t have the benefit of seeing the rest of the chart in front of you, and the intrinsic fair value (blue line) is your calculated estimate of what the stock is worth rather than an absolute truth.

By sticking to sound value investing principles, however, you can do well. As can be seen in the chart, the fair value of a healthy company will be far less volatile than the stock price can potentially be, with only minor adjustments occurring each year based on new information.

How to Calculate Intrinsic Value

In order to buy at an undervalued price, you’d first have to know what the fair price is. This combines art and science. The science is that given perfect company estimates and your target rate of return, you can easily calculate the objective fair value of any business or asset that produces cash flow. The art is that of course you don’t have the perfect estimates, you only have your imperfect approximations. You can make estimates based on historical growth rates, or based on future trends that could shape those growth rates, based on analysis of how the company is spending its cash, or based on realistic management projections and a pattern of meeting those projections.

Discounted Cash Flow Analysis (DCFA) is the fundamental stock valuation methodfor any asset or business that produces cash flows. When this method is applied on a share-by-share basis of a dividend stock, then it’s called either the Dividend Discount Model or Method (generally), or the Gordon Growth Model (under expectations of a perpetual static growth rate).

DCFA and the associated DDM produce perfect fair values given perfect inputs, although of course you’re always going to have imperfect inputs. And the longer the actual stock price remains under the calculated fair value, the better it is for an investor assuming that you’re reinvesting dividends, buying more shares, or the company is repurchasing its own shares.

How Big of a Margin of Safety is Sufficient?

The size of the margin of safety will vary based on investor preference and the type of investing that she or he does.

“Deep Value Investing” refers to buying stock in seriously undervalued businesses. The goal is to find significant mismatches between the current stock prices and the intrinsic value of those stocks. Due to the degree of difference, these companies are often either small, or in bad shape. If they were well known and in good shape, then there would hardly ever be a serious mismatch of value and price except possibly for major macroeconomic deterioration such as during the local market bottom of early 2009. So deep value investing requires guts. You’ve got to pick through the rubble and find value where others aren’t seeing it. You have to see information that others are not seeing, or you have to interpret and act on information that others have, but are misinterpreting or failing to act on. Needless to say, deep value investing requires a considerably large margin of safety to invest with and isn’t for most casual investors.

“Growth at a Reasonable Price (GARP) Investing” refers to a more balanced approach. With this investing method, you pick companies that have positive growth rates that are also trading somewhat below your intrinsic fair value calculation. Dividend Growth Investing falls closer to GARP investing than deep value investing, because dividend growth investing relies on selecting companies with wide moats, strong balance sheets, the ability to grow dividends through recessions, and a product or service that you can see existing and indeed flourishing 10 or 20 years from now. With GARP investing or Dividend Growth Investing, it’s important to have at least a 10% margin of safety, but it’s not very often that you’re going to find enormous differences between price and value which allows you to buy with a huge margin of safety. They’re more stable and less contrarian selections. So rather than investing with access to better information or interpretations than others, you’re merely investing with a different time horizon. While others may be fretting about a quarterly report or something Congress did or a jobs report, you’re focusing on your passive income goals a 5-10 years from now.

How to Find Undervalued Stocks

Earlier this year I published the Dividend Toolkit for readers, which along with a comprehensive investing guide, includes the spreadsheet that I developed for myself to use to calculate the fair price of stocks.

If you want to calculate the fair value of a stock using the Dividend Discount Model (which is explained in significantly more detail in the book), and you estimate that the dividend will grow by 5% per year, and you’re using 12% as your discount rate. First, you put the simple inputs into the Dividend Discount Model spreadsheet tool:

And the tool instantly updates the output chart to tell you the fair value of the stock:

This output chart will not only tell you the fair stock value based on those inputs, but will also tell you the fair stock value based on nearby inputs. In this example, in addition to calculating the results for 5% dividend growth and a 12% discount rate, it will automatically show what the fair value is if it turns out that the stock only grows its dividend by 4%, or if you use a discount rate of 11% instead.

There are four different tools in the spreadsheet tool, including DCFA and DDM models. All of them focus on showing what kind of margin of safety you have based on your inputs, and the static-growth models also show what kind of rate of return you can expect given certain growth outcomes.

Besides the Toolkit, there are other ways to calculate fair price as well. You can do the simplest versions with a calculator or with free online tools. You can develop your own model if you have the time and desire.

A Margin of Safety BOOSTS Returns Rather than Just Providing Protection

Value investing or dividend investing may often be thought of as conservative investing methods, and this may be true in many cases. But the purpose of a margin of safety is not just to protect your rate of return, but indeed to improve it.

When you buy a stock below calculated fair value, an expectation is that in some future time, the stock price will go back up to fair value in a rational market. If your growth expectations end up being correct, and you bought at an undervalued price, then you should eventually get a superior rate of return.

Alternatively, the longer the stock remains undervalued, the better it is for shareholders, because their reinvested dividends, or their new purchases, or management’s share buybacks, continue to accumulate undervalued shares. It actually becomes a demonstrably negative scenario for a long term investor when their stocks go up above fair value.

Buffett put it concisely in his 2011 shareholder letter:

Today, IBM has 1.16 billion shares outstanding, of which we own about 63.9 million or 5.5%. Naturally, what happens to the company’s earnings over the next five years is of enormous importance to us. Beyond that, the company will likely spend $50 billion or so in those years to repurchase shares. Our quiz for the day: What should a long-term shareholder, such as Berkshire, cheer for during that period?

I won’t keep you in suspense. We should wish for IBM’s stock price tolanguish throughout the five years.

Let’s do the math. If IBM’s stock price averages, say, $200 during the period, the company will acquire 250 million shares for its $50 billion. There would consequently be 910 million shares outstanding, and we would own about 7% of the company. If the stock conversely sells for an average of $300 during the five-year period, IBM will acquire only 167 million shares. That would leave about 990 million shares outstanding after five years, of which we would own 6.5%.

If IBM were to earn, say, $20 billion in the fifth year, our share of those earnings would be a full $100 million greater under the “disappointing” scenario of a lower stock price than they would have been at the higher price. At some later point our shares would be worth perhaps $1.5 billion more than if the “high-price” repurchase scenario had taken place.

The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day’s supply.

Source: Berkshire Hathaway Shareholder Letter, Warren E. Buffett

That’s how Buffett made 30-50% returns in his early days. He wasn’t investing in companies that were growing earnings by 30-50% per year; he was investing in companies that were seriously undervalued. Eventually, those stocks will return to normal values, and the longer they don’t, the better it is for the investor.

(Note: Rather than picking large caps like IBM, he was a deep value investor, finding huge mismatches between price and value. As his base of capital grew, it was no longer economical for him to invest in small companies and he either had to buy whole companies or invest primarily in large caps that either have GARP or dividend growth characteristics.)

Margin of Safety Example: 
Here’s an example of how an undervalued stock selection can offer outsized returns.

Suppose you use the Toolkit Spreadsheet or some other Dividend Discount Model tool to determine the fair price of a stock. Let’s use the above example, where it was calculated that a company paying $1.80 in dividends per share this year and growing that dividend by an average of 5% per year into the future, with a discount rate of 12%, is worth $27/share.

What this means is that if the company performs as expected, then buying at $27 should give you long-term returns of around 12% per year. Now, in any given year, the stock may go up or go down; it could fluctuate wildly around that fair value. And of course you’ve got to occasionally adjust your fair value assessment to take into account new information (like how this site re-analyzes the companies I cover on an annual basis). But over the long run, earnings determines price.

For example, let’s say that the stock that pays $1.80 in dividends per share (DPS) this year has $2.50 in earnings per share (EPS) this year. If you pay $27/share for the stock, then you’re paying a price-to-earnings ratio (P/E) of 10.8, and the stock has a dividend yield of 6.67%.

Ten years from now, if it grew earnings and the dividend by 5% per year as expected, then their dividends per share are now $2.93 and the EPS is up to $4.07. This is their fundamental performance, but let’s see two different buying scenarios.

Scenario A: Buy at Fair Value
In this scenario, the investor buys 100 shares at $27, for a total investment of $2,700 and a total dividend income stream of $180/year. If the company grows EPS and the dividend by 5% per year for the next ten years as expected, and if the investor reinvests her dividends each year, then by the end of the 10 year period if the stock remains at fair value for this whole time, she’ll have over 190 shares at a price of nearly $44 each, and so her total investment will be worth $8,385 and her annual dividend income will be $559.

Now, that’s an increase in wealth from $2,700 to $8,385 over a 10 year period, which translates into a 12% annualized rate of return. (The rate of return matched the discount rate that was used to calculate fair value in the first place.) Dividend income rose from $180 to $559, which is also a 12% growth rate (which includes the natural dividend growth and the accumulation of more shares due to dividend reinvestment.)

Scenario B: Buy at 15% Discount to Fair Value
In this scenario, the fundamentals of the stock are identical. The initial EPS and DPS, and their growth rates through the 10 year period are identical to scenario A.

But this time, the market is depressed, and the investor buys shares at a 15% discount to her calculated fair value of $27, which means she buys the shares at $22.95. She can buy 100 shares for $2,295, and will have the same $180 annual dividend stream to reinvest.

Over this ten year period, let’s say the price of the stock gradually increases back up to fair value as the market sees this company continue to perform well. So in the starting period, it’s at a 15% discount, then later only 10%, 5%, and eventually is at fair value. So the price increases from $22.95 to $44. Because shares were cheaper on average over this period but her dividends were the same, she was able to accumulate more shares. By the end, she has around 200 shares at nearly $44 each, for total wealth of $8,768. Her annual dividend income is $584.

So, her investment increased from $2,295 to $8,768 over 10 years, which translates into a 14.3% annualized rate of return. (If she had bought $2,700 worth of shares initially, she could have bought more than 100, and she’d be up to $9,650 or so in wealth.) Her dividend income stream increased from $180 to $584, which is a 12.5% annualized rate of return, and it took significantly less capital to acquire the same income stream (she could have used the initial $2,700 to buy more.)

Same company, same performance, and yet buying at a 15% discount to fair value meant 14.3% annualized returns instead of 12% annualized returns. This means more money in the end, and larger income streams.

Conclusion

As a recap, the purpose of buying with a margin of safety is twofold:

1) It makes your portfolio more conservative because your growth estimates could be a little bit off and the investment will still work out.

2) If your estimates are correct, then your rate of return will be superior over time because the growth rate of the investment is augmented by the additional fact that you bought it at an undervalued price. Over the longest term, your results will be superior either because the market eventually returns the price to its fair value, or because for as long as its under its fair value, your reinvested dividends or the company’s share repurchases will be able to buy more shares for the same amount of money.

To calculate intrinsic fair value, the fundamental way is to use a version of Discounted Cash Flow Analysis, either on the company as a whole or on a share of a dividend paying company. When it’s done in the second way it’s called the Dividend Discount Model. The inputs you’ll need are the current free cash flow or dividend, the estimated growth of that free cash flow or dividend, and a discount rate, which is equal to your target rate of return for practical purposes. When DCFA is understood, then there are shortcuts that allow for reasonable valuation such as basing estimates on P/E, the PEG ratio, or shareholder yield, etc.

http://dividendmonk.com/margin-of-safety/

Definition of 'Margin Of Safety'

Definition of 'Margin Of Safety'

A principle of investing in which an investor only purchases securities when the market price is significantly below its intrinsic value. In other words, when market price is significantly below your estimation of the intrinsic value, the difference is the margin of safety. This difference allows an investment to be made with minimal downside risk.

The term was popularized by Benjamin Graham (known as "the father of value investing") and his followers, most notably Warren Buffett. Margin of safety doesn't guarantee a successful investment, but it does provide room for error in an analyst's judgment. Determining a company's "true" worth (its intrinsic value) is highly subjective. Each investor has a different way of calculating intrinsic value which may or may not be correct. Plus, it's notoriously difficult to predict a company's earnings. Margin of safety provides a cushion against errors in calculation.



Investopedia explains 'Margin Of Safety'

Margin of safety is a concept used in many areas of life, not just finance. For example, consider engineers building a bridge that must support 100 tons of traffic. Would the bridge be built to handle exactly 100 tons? Probably not. It would be much more prudent to build the bridge to handle, say, 130 tons, to ensure that the bridge will not collapse under a heavy load. The same can be done with securities. If you feel that a stock is worth $10, buying it at $7.50 will give you a margin of safety in case your analysis turns out to be incorrect and the stock is really only worth $9.

There is no universal standard to determine how wide the "margin" in margin of safety should be. Each investor must come up with his or her own methodology.

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