DCF analysis is the most popular valuation methodology today. Growth (or lack of it) is an integral to a valuation exercise.

Discounted Cash Flow analysis to determine Intrinsic Value

The value of a business, a share of stock, or any other productive asset is the present value of its future cash flows.

Discounted cash flow (DCF) analysis (intrinsic value principle of John Burr Williams) is the most popular valuation methodology today.

Its popularity, however, hides the important reality that value is easier to define than to measure (easier said than done).

The tools Graham (margin of safety principle) and Fisher (business franchise principle) developed remain crucial in this exercise.



Value stocks versus Growth stocks:  this distinction has limited difference.

One hazard of undue reliance on DCF analysis is a temptation to classify stocks as either value stocks or growth stocks.  It is a distinction with limited difference.

Value a business (or any productive asset) requires estimating its probable future performance and discounting the results to present value.

The probable future performance includes whatever growth (or shrinkage) is assumed.

So growth (or lack of it) is integral to a valuation exercise.

Investing is the deliberate determination that one pays a price lower than the value being obtained.

Only speculators pay a price hoping that through growth the value rises above it.



Conventional Value Investing = low P/E, low P/BV and high DY companies

Value investing is conventionally defined as buying companies bearing low ratios of price-to-earnings, price-to-book value, or high dividend yields.

But these metrics do not by themselves make a company a value investment.  It is not that simple.

Nor does the absence of such metrics prevent an investment from bearing a sufficient margin of safety and qualitative virtues to justify its inclusion in a value investor's portfolio.




Growth doesn't equate directly with value either.

Growing earnings can mean growing value.

But growing earnings can also mean growing expenses, and sometimes expenses growing faster than revenues.

Growth adds value only when the payoff from growth (revenue) is greater than the cost of growth (expenses).

A company reinvesting a dollar of earnings to grow by 99 cents is not helping its shareholders and is not a value stock, though it may be a growth stock.




Read also:

Value Vs Growth

http://klse.i3investor.com/blogs/kcchongnz/45456.jsp

What drives the return of your stock investment, Growth or Value?

http://klse.i3investor.com/blogs/kcchongnz/81690.jsp

“In our opinion, the two approaches (value and growth) are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive…In addition, we think the very term “value investing” is redundant. What is “investing” if it is not the act of seeking value at least sufficient to justify the amount paid?”      Warren Buffett Letters to investor, 1992.

"Margin of Safety" as the Central Concept of Investment

The Intelligent Investor by Benjamin Graham

Chapter 20 - “Margin of Safety” as the Central Concept of Investment

A single quote by Graham on page 516 struck me:

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.
Basically, Graham is saying that most stock investors lose money because they invest in companies that seem good at a particular point in time, but are lacking the fundamentals of a long-lasting stable company.

This seems obvious on the surface, but it’s actually a great argument for thinking more carefully about your individual stock investments. If most of your losses come from buying companies that seem healthy but really aren’t, isn’t that a profound argument for carefully studying any company you might invest in?

MARGIN OF SAFETY CONCEPT: STOCKS SHOULD BE BOUGHT LIKE GROCERIES, NOT LIKE PERFUME

The high CAGR in the early years of the investing period, due to buying at a discount, tended to decline and approach that of the intrinsic EPS GR of the companies over a longer investment time-frame.

Notes from Seth Klarman's Margin of Safety

Notes_To_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.

http://www.coattailinvestor.com/

Margin of safety

Margin of safety (safety margin) is the difference between the intrinsic value of a stock and its market price.

Another definition: In Break even analysis (accounting), margin of safety is how much output or sales level can fall before a business reaches its breakeven point.


History

Benjamin Graham and David Dodd, founders of value investing, coined the term margin of safety in their seminal 1934 book, Security Analysis. The term is also described in Graham's The Intelligent Investor. Graham said that "the margin of safety is always dependent on the price paid" (The Intelligent Investor, Benjamin Graham, Harper Business Essentials, 2003).

Application to investing

Using margin of safety, one should buy a stock when it is worth more than its price on the market. This is the central thesis of value investing philosophy which espouses preservation of capital as its first rule of investing. Benjamin Graham suggested to look at unpopular or neglected companies with low P/E and P/B ratios. One should also analyze financial statements and footnotes to understand whether companies have hidden assets (e.g., investments in other companies) that are potentially unnoticed by the market.

The margin of safety protects the investor from both poor decisions and downturns in the market. Because fair value is difficult to accurately compute, the margin of safety gives the investor room for investing.

A common interpretation of margin of safety is how far below intrinsic value one is paying for a stock. For high quality issues, value investors typically want to pay 90 cents for a dollar (90% of intrinsic value) while more speculative stocks should be purchased for up to a 50 percent discount to intrinsic value (pay 50 cents for a dollar).

Application to accounting

In accounting parlance, margin of safety is the difference between the expected (or actual) sales level and the breakeven sales level. It can be expressed in the equation form as follows:

Margin of Safety = Expected (or) Actual Sales Level (quantity or dollar amount) - Breakeven sales Level (quantity or dollar amount)

The measure is especially useful in situations where large portions of a company's sales are at risk, such as when they are tied up in a single customer contract that may be canceled.


Formula

Margin of Safety = Actual Sales - Breakeven Sales

Reference

• Graham, Benjamin. Dodd, David. Security Analysis: The Classic 1934 Edition. McGraw-Hill. 1996. ISBN 0-07-024496-0.
• http://www.businessweek.com/magazine/content/06_32/b3996085.htm
• http://www.worldfinancialblog.com/investing/ben-grahams-margin-of-safety/26/

Notes

1. ^ Yee, Kenton K. (2008). "Deep-Value Investing, Fundamental Risks, and the Margin of Safety". Journal of Investing 17 (3): 35–46. doi:10.3905/JOI.2009.18.1.027.
2. ^ http://www.accountingtools.com/article-metric-margin-of-safet

External links

• http://www.worldfinancialblog.com/investing/ben-grahams-margin-of-safety/26/

From Wikipedia, the free encyclopedia

Margin of Safety - The Three Most Important Words in Investing (Benjamin Graham)

Margin of Safety

1.  Knowing how to compute intrinsic value is just the beginning of valuing a company.

2.  You will be able to appreciate intrinsic value more accurately only when it is deducted from the market price to determine its margin of safety.

3.  Having a margin of safety does not guarantee a successful investment, but it takes care of downside to minimize errors.

4.  It helps to eliminate capital losses or reduce investment risks.

5.  When you have a margin of safety, it will serve as a buffer for any investment and leave room for errors in the event that wrong assumptions were made during the period of valuing a stock.

6.  Capital preservation is the first rule in investing.

7.  We invest only when the risk is reduced to its minimum.

8.  In investing, we need to have good protection (insurance) for our investments - a margin of safety.

9.  The wider the margin, the more protection we will have.

10.  With a margin of safety, the success in investing is not dependent on the exact intrinsic value; the margin of safety serves as better protection against wrong assumptions.

11.  A margin of safety is affected by intrinsic value and the market price.

12.  When the intrinsic value and share price of a company change, the margin of safety will change.

13.  These are three most important terms when using margin of safety:  Undervalued, Fair Value, and Overvalued.

14.  Undervalued:  Intrinsic value $1.  Market price $0.50

15.  Fair value:  Intrinsic value $1.  Market price $1.

16.  Overvalued:  Intrinsic value $1.  Market price $1.50.

17.  There is no hard-and-fast rule regarding how much margin of safety needs to be in place in order for you to become a prudent investor.

18.  Obviously, a 50% margin of safety will generally be better than paying a fair price (0% margin of safety) for the same company.

19.  The wider the margin of safety, the better you will be protected should a financial crisis hit, or when you make a wrong assumption.

20.  However, there are companies, like blue-chip companies that are unlikely to sell at a bargain price with a margin of safety of more than 50%.

21.  Since most blue-chip companies are not growth companies, they will normally trade at a fair price or even be overvalued, rather than being priced at a bargain price, even during times of crisis.

22.  Warren Buffett's statements about quality companies:  "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

23.  The best time to have a great margin of safety is when the market is depressed or when a company is heavily punished by the market due to bad news.

24.  Remember Ben Graham, the market is there to serve us and not to guide us.

25.  You should take such period of market sell-down or stock sell-down as an opportunity to scoop up bargain stocks.

26.  During this period, average investors would not dare to enter the stock market, for fear that prices would continue to drop.

27.  Be greedy when others are fearful!

28.  Understandably, it can be very difficult to make a purchase when the investment mood and environment are shrouded with negativity.

29.  Investors who can overcome this and take action regardless of market pessimism will definitely become very successful.

30.  Teach and prepare yourself to buy growth companies at a low price (undervalued) and sell them ( if you intend to ) when the price is higher or overvalued.

31.  Teach and prepare yourself to avoid buying a stock when it is overvalued (e.g. negative margin of safety).

32.  Warren Buffett once said, "It is better to be approximately right than precisely wrong."

34.  Caution:  Calculating the intrinsic value should be used only to determine WHEN investors want to enter or exit the stock market.  It should not be used to determine the QUALITY of the stock.

35.  The price is mainly determined on market sentiments and not the quality of the stock.

36.  During the 2008-2009 crisis, some growth companies did not continue to grow after the price correction, owing to the respective growth factors of companies.

37.  On the other hand, there are growth companies that continue to grow consistently even in a bear market.



Margin of Safety (Intrinsic value / Market Price)

Positive
>50%         ACTION: BUY (undervalued)
50% - 0%  ACTION:  BUY/HOLD (fair value)

Negative
> -10%      ACTION:  SELL/HOLD (fair value-overvalued)
> - 50%     ACTION:  SELL (grossly overvalued)

Margin of Safety. Paying Up Doesn't Pay Off

Paying Up Doesn't Pay Off
	1999	2004	1999	2004	5-Year	5-Year
	P/E	P/E	Price $	Price $	EPS Growth	Total Return
Coca Cola	47	20	58	42	66%	-28%
Pfizer	42	13	32	27	165%	-16%
Wal-Mart	58	23	69	53	93%	-23%
Dell	75	35	51	42	78%	-18%
Microsoft	78	21	58	27	69%	-53%
Intel	36	21	41	24	-4%	-41%
Cisco	134	24	54	19	100%	-65%
Average	67	22	52	33	81%	-35%

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.

Buying Good Quality Stock versus Buying Poor Quality Stock

Graham, Chapter 20:

Chapter 20 is entitled "Margin of Safety as the Central Concept of Investment" (p. 512). I think this chapter sums up Graham's investing philosophy. 

He not only covers the risk of buying a good quality stock at a high price, but buying a poor quality stock at a high price during an up-trending market. The latter is one of the riskier moves you can do with your money in the context of the margin-of-safety. On the other hand, purchasing stock in a good quality company, even if it's at a high price, will ultimately end up being the better choice.

One other important point in this chapter is the mention of diversification as a tool of safety, not perfection. While he doesn't go into specific methods of diversification, Graham does point out that even if one stock tanks, diversifying your portfolio "guarantees only that (you) have a better chance for profit than for loss - not that loss is impossible" (p. 518).

Intelligent Investor 

by Benjamin Graham

Main lesson:  

Buying a poor quality stock at a high price during an up-trending market is one of the riskier moves you can do with your money in the context of the margin of safety.   AVOID.  AVOID.  AVOID.

How do you value this company XYZ?

I have been looking at this company.  Its business is doing very well.  It has grown its revenues, profit before tax and earnings consistently over the last few years.  Its business is growing and it is opening new branches in various towns/cities in our country.

Its net profit margins are high (>20%), its ROE is high (> 25%) and it pays about 30%+ of its earnings as dividends.

Its trailing-twelve months earnings was $113.1 million and its market capitalisation recently was $1642 million.


How would you value the earnings and dividends of this company?

Using the thinking similar to that of Buffett:

1.  The risk free interest rate offered by the banks is 4% per year.
2.  How much deposit would you need to put in the bank to earn $113.1 million per year?
3.  Answer:  $113.1 million / 4% = $2827.5 million.
4.  This company pays out 30%+ of its earnings as dividends, i.e. about $40 million.
5.  How much deposit would you need to put in the bank to earn $40 million at present prevailing interest rate of 4% per year?
6.  Answer:  $40 million / 4% = $1000 million.
7.  A fixed deposit gives you a fixed interest rate of the same amount every year, assuming that the interest rate paid remains unchanged.
8.  On the other hand, this company's earnings are expected to grow quite fast in the coming years.
9.  Assuming that this company can grow its earnings at a very low 2% per year for the next few years, with a high degree of predictability, how would you value this company?
10.  Let's continue with the analogy above.
11.  With its earnings of $ 113.1 million, growing at 2% per year, you will need to have a fixed deposit of the equivalent of $ 113.1 million / (4% - 2%) = $ 5655 million.
12.  With its dividend of $ 40 million, growing at 2% per year, you will similarly have to have a fixed deposit of the equivalent of $ 40 million / (4% - 2%) = $ 2000 million.


To summarise:

Assuming no growth in its earnings or dividends, and using 4% risk free interest rate as the discount factor, the present values of
- the earnings stream is the equivalent to an asset of $ 2827.5 million.
- the dividends stream is the equivalent to an asset of $1000 million.

When growth is factored into the earnings and dividends stream, even at a low rate of growth of 2% and still using the 4% risk free interest rate as the discount factor, the present values of:
- the earnings stream is $ 5655 million.
- the dividends stream is $ 2000 million.

This company's market capitalization was $ 1642 million recently.  Assuming no growth in the earnings of this company, the value of this company is anywhere between $1000 million (this price is supported by its dividend yield) and $2827.5 million (supported by its earning yield).

At $ 1642 million, its reward:risk ratio = 64.9%: 35.1%.


Conclusion:

Since, this company is projected to grow its earnings with a high degree of predictability, at its present price of $ 1642 million, those who are buying into this company at the present price, enjoy a large margin of safety.

The three most important words in the books of Benjamin Graham

Yes, these are the three most important words in the books of Benjamin Graham.

If you have to take home a message from his thick books, it is knowing everything about "Margin of Safety".

Better still, tattoo these three words to your body, so that you can be reminded every minute of the day. 

This strategy is very safe for selected high quality stocks. Margin of Safety Principle

The downside risk is protected through ONLY buying when the price is low or fairly priced.  


Therefore, when the price is trending downwards and when it is obviously below intrinsic value, do not harm your portfolio by selling to "protect your gains" or "to minimise your loss."  


Instead, you should be brave and courageous (this can be very difficult for those not properly wired)  to add more to your portfolio through dollar cost averaging or phasing in your new purchases.  This strategy is very safe for selected high quality stocks as long as you are confident and know your valuation.  It has the same effect of averaging down the cost of your purchase price. 


 However, unlike selling your shares to do so, buying more below intrinsic value ensures that your money will always be invested to capture the long term returns offered by the business of the selected stock.

A criterion of investment vs. speculation:

Many see no benefit in distinguishing the investor from the speculator.

Graham disagrees -- he believes the margin of safety may be "the touchstone to distinguish an investment operation from a speculative one." 

The speculator believes the odds are in their favor when they take their chance and they might claim a margin of safety as a result from a propitious time, skill in analysis, adviser or system, etc. But these claims are unconvincing.


http://www.conscious-investor.com/books/intelligentinvestor.pdf

The investor's concept of a margin of safety

 The investor's concept of a margin of safety rests upon a simple and definite arithmetical reasoning from statistical data.

1. There is no guarantee that the fundamental quantitative approach will be successful in the future, but no reason for pessimism. 
2. "To have a true investment there must be present a true margin of safety." 

"It is our argument that a sufficiently low price can turn a security of mediocre quality into a sound investment opportunity--provided

• that the buyer is informed and experienced and 
• that he practices adequate diversification. 

For if the price is low enough to create a substantial margin of safety, the security thereby meets our criterion of investment.


http://www.conscious-investor.com/books/intelligentinvestor.pdf

BENJAMIN GRAHAM - THE MARGIN OF SAFETY

Benjamin Graham tells us that investment policy can be reduced to three simple words: "Margin of Safety" - the price at which a share investment can be bought with minimal downside risk.

The important point here is that the margin of safety price is not the same as the price that an investor calculates a share to be intrinsically worth.

THE INTRINSIC VALUE OF A SHARE

An investor may calculate the intrinsic value of a share by differing methods and will eventually come up with a price that he or she believes represents good buying value. Graham had his methods of calculating intrinsic value, Warren Buffett has his, other successful investors have theirs.

Graham acknowledges, however, that calculations may be wrong, or that external events may take place to affect the value of the share. These cannot be predicted. For these reasons, the investor must have a margin of safety, an inbuilt factor that allows for these possibilities.

PRIME BONDS VS GOVERNMENT BONDS

For Benjamin Graham, the benchmark for calculating the margin of safety was the interest rate payable for prime quality bonds. As Graham wrote in an era when prime bonds were much more prominent, it is more practical now to adopt, as Warren Buffett apparently does, the rate of return of government bonds as the benchmark.

Graham then uses a comparative approach. If the risk in two forms of investment is the same, then it must be better to take the investment with the higher return. Conversely, an investment with higher risk, such as shares, should, when calculating the margin of safety, have a higher return

EXAMPLE

Modifying then the example that Benjamin Graham uses in his book, we can take a share investment that is yielding 10 per cent earnings. For example, company A is earning 90 cents per share and is selling in the market at 10 dollars. If the rate of return on government bonds is 5 per cent, then the share is yielding annually an excess of 5 per cent. Over a period of ten years, the excess yield will total about 50 per cent, which, in Graham’s opinion, may be enough, if the share investment was wisely chosen in the first place. Of course, the total margin of safety will fluctuate depending upon the quality of the share investment.

Even so, something may go wrong. Graham believes however, that, with a diversified portfolio of 20 or more representative share investments, the margin of error approach will, over time, produce satisfactory results.

 ACCORDING TO BENJAMIN GRAHAM:

"[To] have a true investment, there must be a true margin of safety. And a true margin of safety is one that can be demonstrated by figures, by persuasive reasoning, and by reference to a body of actual experience".

http://www.buffettsecrets.com/margin-of-safety.htm

Warren Buffett Secrets

http://www.buffettsecrets.com/index.htm

A notable feature of value investing is its strong performance in periods of overall market decline.

Whenever the financial markets fail to fully incorporate fundamental values into securities prices, an investor's margin of safety is high.

• Stock and bond prices may anticipate continued poor business results, yet securities priced to reflect those depressed fundamentals may have little room to fall further. 
• Moreover, securities priced as if nothing could go right stand to benefit from a change in perception. If investors refocused on the strengths rather than on the difficulties, higher security prices would result. 
• When fundamentals do improve, investors could benefit both from better results and from an increased multiple applied to them.

Example:


In early 1987 the shares of Telefonos de Mexico, S.A., sold for prices as low as ten cents. The company was not doing badly, and analysts were forecasting for the shares annual earnings of fifteen cents and a book value of approximately seventy-five cents in 1988. Investors seemed to focus only on the continual dilution of the stock, stemming from quarterly 6.25 percent stock dividends and from the issuance of shares to new telephone subscribers, ostensibly to fund the required capital outlays to install their phones. The market ignored virtually every criterion of value, pricing the shares at extremely low multiples of earnings and cash flow while completely disregarding book value.

In early 1991 Telefonos's share price rose to over $3.25. The shares, out of favor several years earlier, became an institutional favorite. True, some improvement in operating results did contribute to this enormous price appreciation, but the primary explanation was an increase in the multiple investors were willing to pay. The higher multiple reflected a change in investor psychology more than any fundamental developments at the company.




Ref:  Margin of Safety by Seth Klarman

Should investors worry about the possibility that business value may decline? Absolutely.

The possibility of sustained decreases in business value is a dagger at the heart of value investing (and is not a barrel of laughs for other investment approaches either). Value investors place great faith in the principle of assessing value and then buying at a discount. If value is subject to considerable erosion, then how large a discount is sufficient?

Should investors worry about the possibility that business value may decline? Absolutely. Should they do anything about it? There are three responses that might be effective.

• 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. 
• Second, investors fearing deflation could demand a greater than usual discount between price and underlying value in order to make new investments or to hold current positions. This means that normally selective investors would probably let even more pitches than usual go by. 
• Finally, the prospect of asset deflation places a heightened importance on the time frame of investments and on the presence of a catalyst for the realization of underlying value. In a deflationary environment, if you cannot tell whether or when you will realize underlying value, you may not want to get involved at all. If underlying value is realized in the near-term directly for the benefit of shareholders, however, the longer-term forces that could cause value to diminish become moot.

Ref:  Margin of Safety by Seth Klarman

Can You Sum Up Your Investing Philosophy in 10 Words?

By Jason Zweig

Associated Press

Abraham Lincoln in 1858

In a speech to the Wisconsin State Agricultural Society in Milwaukee on Sept. 30, 1859, Abraham Lincoln told this anecdote:

“It is said an Eastern monarch once charged his wise men to invent him a sentence, to be ever in view, and which should be true and appropriate in all times and situations. They presented him the words: ‘And this, too, shall pass away.’ How much it expresses! How chastening in the hour of pride!—how consoling in the depths of affliction! ‘And this, too, shall pass away.’  And yet let us hope it is not quite true.”

I was recently reminded of Lincoln’s wonderful speech when someone asked me if I could summarize my investing beliefs in no more than 10 words. I laughed and said, “Of course not!”

But right afterward, I realized to my surprise that I could. I banged this out almost instantly:

Anything is possible, and the unexpected is inevitable. Proceed accordingly.

I asked some leading investors and financial thinkers for their own contributions.  Here are a few:

Determine value.  Then buy low, sell high.  ;-)

—David Herro, chief investment officer for international equities, Harris Associates, and manager of Oakmark International Fund

If everybody wants it, I don’t. Avoid crowds.

—Gus Sauter, chief investment officer, the Vanguard Group

Other people are smarter than you think they are.  Index.

—Laurence B. Siegel, research director, Research Foundation of the CFA Institute

Risk means more things can happen than will happen.

—Elroy Dimson, expert on long-term stock returns, London Business School, and co-author, “Triumph of the Optimists”

Invest for the long term and ignore interim aggravation.

– Charles D. Ellis, director, Greenwich Associates, and author, “Winning the Loser’s Game”

100% of business value depends on the future.

—Bill Miller, chairman and chief investment officer, Legg Mason Capital Management

Plan for the worst. Hope for the best.

—Robert Rodriguez, managing partner, First Pacific Advisors

Control what you can: your savings rate, costs, and taxes.

– Don Phillips, president, fund research, Morningstar

In the end, you cannot take your investments with you.

– Meir Statman, finance professor, Santa Clara University, and author, “What Investors Really Want”

The less portfolio management costs, the more you earn.

—Burton Malkiel, professor of economics emeritus, Princeton University, and author of “A Random Walk on Wall Street”

Own competently managed, competitively advantaged businesses at discounted prices.

—O. Mason Hawkins, chairman and chief executive officer, Southeastern Asset Management

Do the math. Expect catastrophes. Whatever happens, stay the course.

– William J. Bernstein, Efficient Frontier Advisors, and author, “The Four Pillars of Investing”

Fallible, emotional people determine price; cold, hard cash determines value.

—Christopher C. Davis, chairman, Davis Advisors and co-manager, Davis New York Venture Fund

New submissions are also coming in:

Save. Invest long-term. Compounding returns builds. Compounding costs destroys. Courage!

–John C. Bogle, founder, the Vanguard Group

Are you smarter than the average professional investor? Probably not.

– William F. Sharpe, emeritus professor of finance, Stanford University, and Nobel Laureate in economics

Finally, it’s worth remembering that the great investing analyst Benjamin Graham engaged in a similar exercise (also evoking Lincoln’s tale) but came in seven words under our maximum:

In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, ‘This too will pass.” Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.”

—Benjamin Graham, “The Intelligent Investor,” Chapter 20.

In the spirit of Lincoln’s classic anecdote, can you sum up your investing philosophy in no more than 10 words that you believe will be “true and appropriate in all times and situations”?

http://blogs.wsj.com/totalreturn/2012/01/27/can-you-sum-up-your-investing-philosophy-in-10-words/?mod=WSJBlog&mod=totalreturn

Margin of Safety Concept in Conventional and Unconventional Investments

 Extension of the Concept of Investment

To complete our discussion of the margin-of-safety principle we must now make a further distinction between conventional and unconventional investments. 

Conventional investments are appropriate for the typical portfolio. 

• Under this heading have always come United States government issues and high-grade, dividend paying common stocks. 
• We have added state and municipal bonds for those who will benefit sufficiently by their tax-exempt features. 
• Also included are first-quality corporate bonds when, as now, they can be bought to yield sufficiently more than United States savings bonds.

Unconventional investments are those that are suitable only for the enterprising investor. They cover a wide range. 

• The broadest category is that of undervalued common stocks of secondary companies, which we recommend for purchase when they can be bought at two-thirds or less of their indicated value. 
• Besides these, there is often a wide choice of medium-grade corporate bonds and preferred stocks when they are selling at such depressed prices as to be obtainable also at a considerable discount from their apparent value. 
• In these cases the average investor would be inclined to call the securities speculative, because in his mind their lack of a first quality rating is synonymous with a lack of investment merit.

It is our argument that a sufficiently low price can turn a security of mediocre quality into a sound investment opportunity—provided that the buyer is informed and experienced and that he practices adequate diversification. 

• For, if the price is low enough to create a substantial margin of safety, the security thereby meets our criterion of investment. 
• Our favorite supporting illustration is taken from the field of real-estate bonds. 
• In the 1920s, billions of dollars’ worth of these issues were sold at par and widely recommended as sound investments. A large proportion had so little margin of value over debt as to be in fact highly speculative in character. 
• In the depression of the 1930s an enormous quantity of these bonds defaulted their interest, and their price collapsed—in some cases below 10 cents on the dollar. 
• At that stage the same advisers who had recommended them at par as safe investments were rejecting them as paper of the most speculative and unattractive type. 
• But as a matter of fact the price depreciation of about 90% made many of these securities exceedingly attractive and reasonably safe—for the true values behind them were four or five times the market quotation.*

The fact that the purchase of these bonds actually resulted in what is generally called “a large speculative profit” did not prevent them from having true investment qualities at their low prices. 

• The “speculative” profit was the purchaser’s reward for having made an unusually shrewd investment. 
• They could properly be called investment opportunities, since a careful analysis would have shown that the excess of value over price provided a large margin of safety. 
• Thus the very class of “fair-weather investments” which we stated above is a chief source of serious loss to naive security buyers is likely to afford many sound profit opportunities to the sophisticated operator who may buy them later at pretty much his own price.†

The whole field of “special situations” would come under our definition of investment operations, because the purchase is always predicated on a thoroughgoing analysis that promises a larger realization than the price paid.  Again there are risk factors in each individual case, but these are allowed for in the calculations and absorbed in the overall results of a diversified operation.

To carry this discussion to a logical extreme, we might suggest that a defensible investment operation could be set up by buying such intangible values as are represented by a group of  “commonstock option warrants” selling at historically low prices. (This example is intended as somewhat of a shocker.)* 

• The entire value of these warrants rests on the possibility that the related stocks may some day advance above the option price. 
• At the moment they have no exercisable value. 
• Yet, since all investment rests on reasonable future expectations, it is proper to view these warrants in terms of the mathematical chances that some future bull market will create a large increase in their indicated value and in their price. 
• Such a study might well yield the conclusion that there is much more to be gained in such an operation than to be lost and that the chances of an ultimate profit are much better than those of an ultimate loss. 
• If that is so, there is a safety margin present even in this unprepossessing security form. 
• A sufficiently enterprising investor could then include an option-warrant operation in his miscellany of unconventional investments.1

* Graham is saying that there is no such thing as a good or bad stock; there are only cheap stocks and expensive stocks. Even the best company becomes a “sell” when its stock price goes too high, while the worst company is worth buying if its stock goes low enough. 

† The very people who considered technology and telecommunications stocks a “sure thing” in late 1999 and early 2000, when they were hellishly overpriced, shunned them as “too risky” in 2002—even though, in Graham’s exact words from an earlier period, “the price depreciation of about 90% made many of these securities exceedingly attractive and reasonably safe.” Similarly, Wall Street’s analysts have always tended to call a stock a “strong buy” when its price is high, and to label it a “sell” after its price has fallen—the exact opposite of what Graham (and simple common sense) would dictate. As he does throughout the book, Graham is distinguishing speculation—or buying on the hope that a stock’s price will keep going up—from investing, or buying on the basis of what the underlying business is worth.

* Graham uses “common-stock option warrant” as a synonym for “warrant,” a security issued directly by a corporation giving the holder a right to purchase the company’s stock at a predetermined price. Warrants have been almost entirely superseded by stock options. Graham quips that he intends the example as a “shocker” because, even in his day, warrants were regarded as one of the market’s seediest backwaters. (See the commentary on Chapter 16.)

Ref:  The Intelligent Investor by Benjamin Graham

CHAPTER 20 “Margin of Safety” as the Central Concept of Investment



Also read:

• Margin of Safety Concept in The Business Venture of Buying and Selling Stocks
• Margin of Safety Concept in Conventional and Unconventional Investments
• Margin of Safety Concept in Speculation and Investment
• Margin of Safety Concept in Diversification
• Margin of Safety Concept in Undervalued or Bargain Stockss
• Margin of Safety Concept in Growth Stocks
• Margin of Safety in Good-Quality and Low-Quality Stocks.
• Margin of Safety Concept in Common Stocks
• Margin of Safety Concept in Bonds and Preferred Stocks

Margin of Safety Concept in Speculation and Investment

A Criterion of Investment versus Speculation

Since there is no single definition of investment in general acceptance, authorities have the right to define it pretty much as they please.

• Many of them deny that there is any useful or dependable difference between the concepts of investment and of speculation. 
• We think this skepticism is unnecessary and harmful. 
• It is injurious because it lends encouragement to the innate leaning of many people toward the excitement and hazards of stock-market speculation. 
• We suggest that the margin-of-safety concept may be used to advantage as the touchstone to distinguish an investment operation from a speculative one.

Probably most speculators believe they have the odds in their favor when they take their chances, and therefore they may lay claim to a safety margin in their proceedings.

• Each one has the feeling that the time is propitious for his purchase, or that his skill is superior to the crowd’s, or that his adviser or system is trustworthy. 
• But such claims are unconvincing. 
• They rest on subjective judgment, unsupported by any body of favorable evidence or any conclusive line of reasoning. 
• We greatly doubt whether the man who stakes money on his view that the market is heading up or down can ever be said to be protected by a margin of safety in any useful sense of the phrase.

By contrast, the investor’s concept of the margin of safety—as developed earlier in this chapter—rests upon simple and definite arithmetical reasoning from statistical data.

• We believe, also, that it is well supported by practical investment experience. 
• There is no guarantee that this fundamental quantitative approach will continue to show favorable results under the unknown conditions of the future. 
• But, equally, there is no valid reason for pessimism on this score.

Thus, in sum, we say that to have a true investment there must be present a true margin of safety. And a true margin of safety is one that can be demonstrated by figures, by persuasive reasoning, and by reference to a body of actual experience.


Ref:  The Intelligent Investor by Benjamin Graham

CHAPTER 20  “Margin of Safety” as the Central Concept of Investment

Also read:

• Margin of Safety Concept in The Business Venture of Buying and Selling Stocks
• Margin of Safety Concept in Conventional and Unconventional Investments
• Margin of Safety Concept in Speculation and Investment
• Margin of Safety Concept in Diversification
• Margin of Safety Concept in Undervalued or Bargain Stocks
• Margin of Safety Concept in Growth Stocks
• Margin of Safety in Good-Quality and Low-Quality Stocks.
• Margin of Safety Concept in Common Stocks
• Margin of Safety Concept in Bonds and Preferred Stocks