All investors buy stocks expecting that future prices will be higher. To them the current price is “undervalued”. Nobody buy stocks thinking that it is currently overvalued.
Value investors is a special group whose idea of value is the value of the underlying business. They buy if the price is significantly lower than the business value as determined by the business fundamentals.
This what differentiate value investors from other types of investing such as those that think the current price is cheap relative to historical prices. There are also those that think current prices are cheap relative to what they think the market will think in the future.
Value investors idea of cheapness is relative the the business value.
The challenge then is how to estimate the business value. Some focus on the Assets of the company as the store of value. Some focus on the earnings power ignoring growth. Others focus on the growth prospects. The common thread is that they all believe that there is a business value and that it is possible to estimate it.
Of course all valuation is based on certain assumptions about the future. As such they look for some margin of safety when determining the value as a risk mitigation process.
The other thing that all value investor believe is that the market does not always reflect the business value. So if the market is very fearful, prices may drop below the business value and vice versa.
So if you are a value investor, you buy when the stock price provides a sufficient margin of safety. Nobody knows where the bottom is going to be. So the entry is more about the margin of safety than some bottom price.
So what is the benefits of value investing? It is a conservative approach. It is based on what a stock is - a real business. There is an economic logic to why prices can go higher than your purchased price
If you want to know more about how to invest based on value investing concepts, I have an ebook.
![[Image: Master-value-investing.png]](https://i.postimg.cc/kgTrkc2V/Master-value-investing.png)
(01-07-2023, 10:12 AM)i4value Wrote: [ -> ]So if you are a value investor, you buy when the stock price provides a sufficient margin of safety. Nobody knows where the bottom is going to be. So the entry is more about the margin of safety than some bottom price.
So what is the benefits of value investing? It is a conservative approach. It is based on what a stock is - a real business. There is an economic logic to why prices can go higher than your purchased price
If you want to know more about how to invest based on value investing concepts, I have an ebook.
I figured out this fallacy back in 2009 and for this reply I had to search my old notes. Frankly, I don't know what to feel for this being extensively taught in "value investing". On one hand I'm sad, on the other I'm secretly laughing.
Imagine buying a toll bridge to collect fees. For safety, you do not allow the usage to exceed the load capacity, and this load capacity is calculated with a "margin of safety". For investment return, it is the amount of toll fees you can collect till the end of life of the bridge.
For the bridge, margin of safety in measured in tonnage whereas rate of return is in $$$. Even the unit of measurement is different! The
price you pay determines the rate of return and not the margin of safety. Same goes for other investments. And I'll share the exact words by the Warren Buffett here.
"
our margin of safety is not in the price we pay, it's in crossing the threshold of being virtually certain we are buying into a business that has durable competitive advantage, one with good economics, and we are buying in with the people who have the passion for the business and are going to run the same way the year after the sold to us that they ran it the year before. So our margin of safety gets more into the qualitative characteristics than the quantitative aspects that you were probably referring to in terms of the Ben Graham's standard of buying a business..."
The margin of safety is an important concept in engineering as all load calculations are base on certain assumptions about how materials behave, etc. Even in a discipline like engineering, not every thing is known. So we have a margin of safety. Now think of a less scientific subject like investing. You are valuing a company based on projecting how it will perform over its future like. You will have to make certain assumptions. And because of this, you adopt a margin of safety to cater for the uncertainty.
So if your computed value is 100 you will take the intrinsic value as 70. Then if the stock is selling at 50 you invest. This margin of safety has nothing to do with how much the stock price can rise. It could rise to 500 if the market sentiment is very bullish.
The margin of safety provides downside protection. It is not about how much you can make.
I know every one likes to quote Buffett about buying great companies. I must admit that I am not good at judging what is a great company. I would have thought that Kodak or Nokia we great companies with big moats. So I avoid all this talk about great moats etc as it can be very subjective. So if a retail investor tells me about moats, etc, in a qualitative way, you must wonder where they get the expertise.
(17-07-2023, 10:41 PM)i4value Wrote: [ -> ]So if your computed value is 100 you will take the intrinsic value as 70. Then if the stock is selling at 50 you invest. This margin of safety has nothing to do with how much the stock price can rise. It could rise to 500 if the market sentiment is very bullish.
The margin of safety provides downside protection. It is not about how much you can make.
You are right that the Margin of Safety is not about how much you can make.
Now, intrinsic value...
(17-07-2023, 11:07 PM)Wildreamz Wrote: [ -> ] (17-07-2023, 10:41 PM)i4value Wrote: [ -> ].. So if a retail investor tells me about moats, etc, in a qualitative way, you must wonder where they get the expertise.
Can't speak for all retail investors. But if I do talk about moat and qualitative etc. I hope I'm judged by the quality of my information and reasoning, and not whether or not I'm an "expert".
For the sake of this thread and Margin of Safety, I would rather apply a buffer (and hence MOS) to the reasonings, assumptions (especially) and information gathering rather than artificially apply a 20% 50% 70% "discount to intrinsic value" where intrinsic value can be calculated by any ____ who plugs in the numbers.
Discount to intrinsic value in not margin of safety.
(18-07-2023, 12:13 AM)cif5000 Wrote: [ -> ] (17-07-2023, 11:07 PM)Wildreamz Wrote: [ -> ] (17-07-2023, 10:41 PM)i4value Wrote: [ -> ].. So if a retail investor tells me about moats, etc, in a qualitative way, you must wonder where they get the expertise.
Can't speak for all retail investors. But if I do talk about moat and qualitative etc. I hope I'm judged by the quality of my information and reasoning, and not whether or not I'm an "expert".
For the sake of this thread and Margin of Safety, I would rather apply a buffer (and hence MOS) to the reasonings, assumptions (especially) and information gathering rather than artificially apply a 20% 50% 70% "discount to intrinsic value" where intrinsic value can be calculated by any ____ who plugs in the numbers. Discount to intrinsic value in not margin of safety.
It is always about how confident I am on what is being offered.
I agree that margins of safety is a concept. There are numerical approaches eg discount to the intrinsic value. But there are other quantitative ones apart from the discount eg I consider a high dividend yield as another margin. Then there are the qualitative ones.
But at the end of the day, all the analysis must flow into the 4 or 5 parameters that determine value - growth, earnings, reinvestments (affecting the FCF and growth), risks (affecting the discount). This is the why I discount the intrinsic value as there are always uncertainty.
Now as to whether it is 30 % or 70%, I use 30% most of the time (except for the Covid period), the stock prices have seldom dropped to below 30% of my buy price. I use the discount as a downside protection.
But it is a good question. How do you set the discount to the intrinsic value?
(17-07-2023, 07:02 PM)cif5000 Wrote: [ -> ]I figured out this fallacy back in 2009 and for this reply I had to search my old notes. Frankly, I don't know what to feel for this being extensively taught in "value investing". On one hand I'm sad, on the other I'm secretly laughing.
Imagine buying a toll bridge to collect fees. For safety, you do not allow the usage to exceed the load capacity, and this load capacity is calculated with a "margin of safety". For investment return, it is the amount of toll fees you can collect till the end of life of the bridge.
For the bridge, margin of safety in measured in tonnage whereas rate of return is in $$$. Even the unit of measurement is different! The price you pay determines the rate of return and not the margin of safety. Same goes for other investments. And I'll share the exact words by the Warren Buffett here.
"our margin of safety is not in the price we pay, it's in crossing the threshold of being virtually certain we are buying into a business that has durable competitive advantage, one with good economics, and we are buying in with the people who have the passion for the business and are going to run the same way the year after the sold to us that they ran it the year before. So our margin of safety gets more into the qualitative characteristics than the quantitative aspects that you were probably referring to in terms of the Ben Graham's standard of buying a business..."
Well, I do have a slightly different interpretation of this "price you pay" and "margin of safety" thing.
First, my definition of "safety" is risk of losing money after accounting for inflation and opportunity costs like the risk free rate of bonds (eg. Spore Saving bonds)
Yes, the price one pays does determine the rate of return, but also the rate of loss (inverse sign). So in a way, "price you pay" can't be totally dissociated from "margin of safety".
But I can appreciate where you are coming from because I also agree this is a fallacy in value investing (ie. price you pay determine margin of safety), fallacy because people tend to think linearly and extremely without considering the exceptions.
So here is my middle path in general, that I have come to appreciate myself:
- The margin of safety when investing in
cheap stocks,
depends more on qualitative analysis (earnings power, moats, structure etc) than quantitative (how much discount is it selling for?)
- The margin of safety when investing in
expensive stocks,
depends more on quantitative analysis (are you paying for a tree-in-the-sky?) than qualitative (earnings power, moats etc)
I have observed that guys focused on value, depends too much on quantitative, while guys focused on growth, depends too much on qualitative. Everyone who is a value guy at heart should learn about how to qualify stocks better because good stocks will never be undervalued. Everyone who is a growth guy at heart should learn never to justify paying nose bleed valuations because most trees don't grow to the sky.
Whether you are a Ben Graham type of value investor or a Warren Buffet type of value investor, we all try to find underpriced stocks. The only way is to have some measure of the intrinsic value so that you can compare price with intrinsic value.
This is where the margin of safety comes in. If price is just about the same as your estimate of intrinsic value, you don't go in because of the uncertainty about estimating the intrinsic value. You look for a margin of safety not because you equate this with what you can make, but rather as downside protection in case you are wrong.
All valuations are based on assumptions about the future. If you paint a very good picture you will get a higher valuation than than based on a less optimistic future.
Now to paint the future you need the company analysis - this requires both qualitative and quantitative analysis. Sure, historical figures are easy to get, but do they represent the future?
Moral of the story. If you are estimating intrinsic value, you must have a margin of safety. Don't confuse it with how much you can make.
I seldom worry about how much I can make when I buy. I worry more about how much I can lose. This is where the margin of safety comes in.
Remember Warren famous 2 rule? Rule 1 - never lose money. Rule 2 - never forget rule 1.