I’d like to introduce the concept of margin of safety as conceived by Warren Buffet and explain with a few examples:
I have seen some posts which advocate investing at all time highs. This is directly against the rule of margin of safety. The margin of safety means you must purchase your desired stock at a discount to the intrinsic value. If the future value of the stock is say 2x-3x its current share price, you already have a margin of safety but still there are a host of factors to consider before investing.
If you invest at an all time high there may be cases where the stock corrects and stays corrected for a long time. Your capital will be locked in for that period of time. You don’t want that. Take Ajax engineering. If you invested at 700-720₹ your capital would be stuck for a while(more than a year) since current price is 580~.
There may be an exception to the above point. If the P/e of the stock is very low and it is at an all time high. In such cases if you get a margin of safety there’s nothing like it! But it’s not wrong to invest if P/e is low. In such cases compare the P/e to the historical P/e over 1-5 years.
Another scenario is when the stock has corrected but P/e is still quite high. You don’t want to invest and may wait for further correction. Ofcourse what is a high p/e or low p/e depends on the stock. In cases of large caps with strong reputation a P/e of 50 is reasonable(Varun Beverages). On the other hand in other companies even a p/e of 40 may be too high(IDFC Bank).
A magical scenario is if you have a very reputable company and P/E is 45-50 after correction. Here you have a magical margin of safety. Varun beverages at 450/- is one example. If you compare with historical P/e of 1-5 years, the current P/e is drastically low. And even otherwise what a solid company for investment! It’s a classic case for employing a good margin of safety.
The margin of safety principle is usually applied to growth companies. Everyone should be looking for growth companies for long term investment to have safety of principal and compounding effect.
As far as small caps are concerned, if the PE is very low compared to peers, the company has good ROE, little to no debt and good cash flows and evolving net profit, or most of these are present, I would say your investment seems ideal. For example, Rakesh Jhunjunwala bought Titan stock when it was very very small and held for years.
But if you are looking to buy stocks to trade in 1-2 weeks or 1-2 months I have no real advice. I think long term and to compound my investments
You define P/E based on economic moat and reputation and size. For example, if Indian Hotels or Varun Beverages have a P/E of 50 it would be considered a great investment today(situation might change later). On the other hand if you have a company like say Paisalo or Federal Bank with a PE of 30, it would be foolish to invest since there’s no margin of safety.
Coming to re-rating and de-rating, a stock re-rates when there is some good annual or quarterly results and the company is doing well for a while. But it may also re-rate for example Godfrey Philips 4-5 months ago acquired Marlboro and saw huge increase in price and rerating. Any kind of general attractiveness causes re-rating. De-rating happens with poor annual or quarterly results or news, but may be also through short term noise. Another way is when investors are tired of seeing the stock move sideways for years then the stock derates. Derating should not be confused with crashes when promoter fraud etc. takes place
@Arjun_Gupta1 can you please explain me why FMCG companies gets a premium valuation.
Ik that zero level of risk gives it a premium but if it giving you let’s say a 1% dividend yield, 2% earnings yield and a growth of let’s say 5-6%.
So what would be the like premium it should command because it’s giving an return in the range of 8-10%.
Although it’s risk free but if you are getting around 11-12% returns in nifty which is also very well diversified and less risky then why not nifty?
Nifty index fund is a really strong investment to make and grow your portfolio.
Infact you really have to have extensive knowledge and time to make a great investment. Also have to read and update yourself everyday.
Investing in fmcg’s like Britannia and Marico right now is not highly advisable because there’s not going to be any outbreak in share price and share price is at an all time high.
Index fund will grow your income with little to no risk. There is a crash about 1/10-12 years. For the next 3-4 years atleast a crash coming in is unlikely and index fund will allow you to grow and spare you the time to study stocks
I think the discussion above puts too much weight on P/E as the primary indicator of margin of safety. In my understanding, margin of safety is not about buying only at low P/E, but about buying a business below its long-term earning power with reasonable downside protection.
P/E by itself can be misleading if used across sectors or without context. Different businesses deserve very different valuation frameworks.
For example:
Banks and NBFCs are balance-sheet driven and are usually valued on P/B, ROE and asset quality, not just P/E.
Cyclical companies should ideally be valued on mid-cycle earnings rather than current P/E.
Consumer businesses with stable cash flows and long runways often trade at higher P/E for long periods.
Capital goods and infra companies often show low P/E near peak earnings and high P/E near the bottom.
So statements like a particular bank being “expensive” only because of P/E don’t capture the full picture. Even Buffett has mentioned that financials are more complex to value and need a different approach.
Also, all-time high prices don’t automatically mean lack of margin of safety. Many long-term compounders have spent most of their lives at ATH. What matters more is whether earnings and cash flows keep compounding. Price corrections are part of the journey; permanent damage to business economics is the real risk.
On re-rating and de-rating, in my view these are mostly structural. Re-rating usually happens when return ratios, earnings quality or industry structure improve over time. De-rating due to long sideways movement is often market impatience rather than deterioration in business fundamentals.
Lastly, Buffett’s investing style itself evolved. Early Buffett focused on very cheap stocks, while later Buffett focused on high-quality businesses at fair prices. Quoting only the low P/E part misses this evolution.
Overall, margin of safety should be looked at in a broader, business-specific context rather than through a single valuation metric. P/E is useful, but it shouldn’t become a rule.
Two topics which excite me is margin of safety and value trap. last month i got a chance to attend parag parikh unit holder meet and there i asked this question.
My perspective is that, Margin of safety is context specific.
For some investors, if the Quality of business is excellent, then even P/E of 50 is acceptable but few others it may look overvalued. Eventually what matters are the returns for an investor.
Over a very long period of 10+ years, value investing with high margin of safety is a low risk approach.
In short term or medium term, momentum, sector rotation, choosing what works for next few years might be more important.
It earns Profit and it can reinvestment (incremental capital) in operating assets
It earns on those incremental capital better
It can run this business for long enough 5) It can survive slowdown without stress on balance sheet
It will only be survive if it has pricing power in most cases
It must grow more than 12% (Non-Negotiable)
If the growth is not smooth that’s fine but on average it should match the 12% growth
12% is the minimum required return other wise your capital will start eroding rapidly.
If you have found such business then next is to understand valuations. Even if you buy such great company at exuberant price it will not create wealth. Why? Future is uncertain. Every business gose through uncertainty. Hope we all understand uncertainty. Company which you are buying today,may have great time so peak margins, good profits and that can take stock price to uncharted territory. Nobody’s fault. It is the nature. You must understand this. If you don’t, you have to pay the price.
Let’s understand what P/E Multiple is?
P/E is 20 literally say that the price you are paying today will take 20 years of current earnings to match the value.
Question to you , can we predict such long road map for any company. It’s very difficult.
Don’t worry!
Some other thing to be considered.
Earning growth - If it earning grows faster than 12% , let say 18% or more then your time span reduces. Your first and core engine. (Non-Negotiable)
Imagine if you buy a stock at reasonable PE multiple and have tremendous growth then market can re-rate (PE Expansion) This is the second engine. You buy at 15 PE and later market re-rate it to 20 then your return will be exponential. As you can see it is like double edged sword. If it compress it kill you and if it expands it reward you.
Operating leverage - Imagine a company improve efficiency means,cost is fixed and profit growing faster each ear. This is you third engine.
Varun beverages example does not fit this scenario. Last two quarters had flat growth and market is assigning 54 PE which is rich valuation. Also base effect has kicked in meaning future growth will be tough.
Just my prespective - Most often i have seen is that P/E is always high, inflated and most of the places where i have found it to be reasonable is in PSU sector. Whichever sector you pick you will find P/E 60,70,80 and yet those companies give returns better, so i think P/B is still a better take - I might be completely wrong but this is how i find it :).
In Indian context, since there is general perception that, businesses are growing better than World average, Mr. Market tends to give higher P/E and some times higher P/B as well.
Many sectors which have P/B close to 1.0 to 2.0 globally, trade in Indian markets at P/B which is much higher, and Same applies to P/E as well.
e.g. Unilever may not trade at P/E of 70, but HUL often trades at such high P/E. Insurance company like ICICI LOMBARD trades at P/B > 5.5 where as Global Insurance companies trade at 1.0 to 1.5 P/B.
Hence, I believe that, an investor may have to look at P/E, P/B and Market Cap/Sales as well. In some cases I have observed that, when stock trades at Low Market Cap/Sales as compared to its historical averages, mostly such stocks get re-rated and there market value move towards 5 Year or 10 Year Median Market Cap/Sales value. This is not always applicable but it happens some times.
There are just my observations and thoughts. I still believe in “Margin of Safety” and always look at high P/E, P/B with caution. (e.g. Pidilite Industries P/E has reduced now after many years.)
First point in first post is about investing at all time high. It seems , it is not discussed in following posts, as more emphasis is given on margin of safety. Normally we fear that investing at All Time High is risky and there is a chance that price may revert to mean. But we forget that a good stock which is growing, when it reaches at 100, which is its ATH, then goes to 200, then 500, then 1000, and then 10,000 , each time that price is its ATH only. So investing at ATH is not a wrong strategy, provided company is growing consistently. If a price is at ATH, its also indicating that something good is happening at fundamental level for the company, either new products are getting launched or new streams of revenues are getting explored, new and attractive acquisitions are getting done. Debts are getting retired, etc. Price is a leading indicator to all of this. We can trust price. ATH investing may be risky for highly cyclical companies like sugar, cement, metals etc, where normally price reversion to means happens.
