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Saturday, 16 January 2010

Get Real, Margin Of Safety

Keep hearing retail value investors chanting their Holy Grail: Margin Of Safety.

What is their Holy Grail all about?

Understanding value investing
Investment Dictionary: Value Investing

The strategy of selecting stocks that trade for less than their intrinsic value. Value investors actively seek stocks of companies that they believe the market has undervalued. They believe the market overreacts to good and bad news, causing stock price movements that do not correspond with the company's long-term fundamentals. The result is an opportunity for value investors to profit by buying when the price is deflated.

Typically, value investors select stocks with lower-than-average price-to-book or price-to-earnings ratios and/or high dividend yields.

Investopedia Says:

The big problem is estimating the intrinsic value. Remember, there is no "correct" intrinsic value. Two investors can be given the exact same information and place a different value on a company. For this reason, another central concept to value investing that of "margin of safety". This just means that you buy at a big enough discount to allow some room for error in your estimation of value.

Also keep in mind that the very definition of value investing is subjective. Some value investors only look at present assets/earnings and don't place any value on future growth. Other value investors base strategies completely around the estimation of future growth and cash flows. Despite the different methodologies, it all comes back to trying to buy something for less than its worth.

Understanding Margin of safety.
By Sham Gad

Warren Buffett calls them "the three most important words in all of investing." Value-investing dean Benjamin Graham gave rise to the term in his classic book The Intelligent Investor, where he devoted an entire chapter to expanding on its importance as the central concept in any investment operation.

The idea of a margin of safety stems from the reality that no investor, not even Buffett, can determine the exact intrinsic value of any business. Because the intrinsic value is derived from an investor's assumptions, the value is merely an approximation. Yes, an investor as skilled as Buffett will probably have a better approximation of intrinsic value than most, but it is still an approximation nonetheless.

(Createwealth8888: Do you really understand why Warren Buffet said this: Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market.

It simply means that even Warren Buffet believe his portfolio could go down by 50% and still within the normal behavior of the market)

This is why the margin-of-safety concept is of paramount importance. It gives the investor a degree of protection from the market's uncertainties. A margin of safety of at least 40% of intrinsic value typically proves satisfactory, although the wider the margin, the better. In any event, you will rarely lose money investing if you always demand a satisfactory margin of safety.

And demanding one means that your first goal will be to focus on return of -- not on -- capital. Once you've determined a floor price based on a fundamental valuation approach, then investing at or below that floor price ensures that your return of capital is not at a high risk of loss.

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Createwealth8888:

Price is what we pay and value is what we perceive in our mind.

Intrinsic value and high margin of safety is not real and only exists in the mind of the retail value investors and perhaps for Warren Buffet and likes of Warren Buffet may be they are nearly real.

The Trouble With Warren Buffett’s Methods

Only when the stock price moves up then part of the intrinsic value can be realized. If the stock price doesn't move up significantly, the retail value investors can continue with their dream of high margin of safety for a long time.

What is the truth behind the concept of margin of safety?

The margin of safety is a concept to protect investing capital against falling stock price and capturing gain in rising stock price.

As a retail investors without superior information sources, is there a simpler way to determine the margin of safety and get real?

Get Real, margin of safety

Margin Of Safety = Realized Profit + Un-realized P/L

When you first enter into a new stock position, your margin of safety is zero or even negative. But, once you have realized some profit on this particular stock, and on the next purchase of the same stock; you will have some margin of safety. Even you buy back the same stock at higher price, the margin of safety is still there but only at a higher capital cost.

Keep on attacking on the same stock and soon you will have a pillow stock - the ultimate Margin Of Safety.

Understanding .. Pillow Stocks Strategy and Payback period

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