From chapter 20 of the book “The Intelligent Investor”, the author tries to make us understand the importance of picking stocks at a discounted rate and how a company with good fundamentals and price can yield us with extraordinary returns.
The three most important words in investing are margin of safetyWarren Buffett
Chapter 20: “Margin of safety” as the central concept of investment
What is margin of safety
Margin of safety is a particular factor one considers while investing so that even if the goes at a loss, there is not much erosion of wealth. In simple terms, margin of safety is the difference between the stock price and its intrinsic value.
Margin of safety implies that the investor buys the stock at a value slightly lower than the intrinsic value of the traded price.
In a scenario, where the intrinsic value of the stock is Rs. 100/-; the intelligent investor will then buy the stock at Rs. 80/-. Thus, Rs. 20/- becomes your margin of safety.
From the above example, it is evident that the investor has purchased the stock at a discounted price. The profit is made at buying the stock at cheap.
Price and value
The prices of the stocks are dynamic. The prices are driven by the demand and supply of those shares in the market. Thus, a company with good fundamentals can continue to under perform till it gets the demand it deserves.
Price is what you pay, value is what you getWarren Buffett
The prices of stock tend to change with time. At times the stocks are highly over values and at times they are under valued. Over a longer course of time, this demand for the stock will eventually be proportional to the fundamental prospects of the company.
If a company is producing good profits year on year, one day the market will surely reward the share holders when handsome returns.
Importance of margin of safety
Margin of safety allows investors to enter an investment with a discount. The investor who bought the stock at a discount has already made a profit in their investment, and its only a matter of time for the returns to be visible.
In the worst case scenario, if the price of the stock still falls further, the investor will not incur much losses. On the contrary, he may even buy more shares of the company to average the gains (only if there is no change in fundamentals).
In the short course of time, the prices of the stock may be volatile. But in the longer course the prices of the stock is bound to go in the direction of the company fundamentals.
In short, select companies with great fundamentals and buy them at the right price by keeping a fair margin of safety.
Risk of paying a high price
Imagine that you find a stock that you think can grow at 10% a year, even if the market grows at 5%. Unfortunately, you are so enthusiastic that you pay too high a price, and the stock loses 50% of its value in the first year. Even if the stock later generates double the market’s return, it will take more 16 years to overtake the market – simply because you paid too much and lost too much, at the outset.
To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks.Page 524, The Intelligent Investor.
Diversification of assets
As per the chapter, there is a close logical connection between the concept of margin of safety and the the principles of diversification. There can be a case where even with a margin of safety, a stock may perform badly. It is impossible to stay away from stock market losses. Thus, diversifying your assets can reduce the overall erosion of your capital.
Also read: How To Achieve Optimal Asset Allocation
Example from the book to explain the concept of diversification and margin of safety
Consider a game of Russian Roulette. If a man bets $1 on a single number he is paid $35. The chances of winning are 37:1. Thus, he has a negative margin of safety. Because if he bets on every number he will bet $37 and win $35 on one number, thereby making a net loss of $2. On the other hand, if he was paid $39 instead of $35, he would make a net profit of $2 every time by betting $1 on each number.
Conventional and unconventional investments
Conventional investments are investment classes that are made readily available for the general public to invest. A typical example of conventional investments are mutual funds. Mutual funds are lower in risk and one can afford not to consider a high margin of safety for such investments.
On the other hand, unconventional investments may be regarded as small cap companies that are unheard of. While investing in such companies it is extremely important to consider a proper margin of safety along with studying the fundamentals. An ideal scenario can be buying stocks at a price of two-third of its intrinsic value.
Invest like its your own business
People consider buying stock as “Buy at 100 levels; sell at 120 levels”. Invest in companies based on the fundamentals of the company and wait for the right time to price your investment at fair valuations.
It’s far better to buy a wonderful company at a fair price, than a fair company at a wonderful priceWarren Buffett
A true investment must have a true margin of safety. And a true margin of safety is one that can be demonstrated by figures and proper reasoning.
Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgement is sound, act on it – even though others may hesitate or differ.Page 524, The Intelligent Investor.