Question to Senior Investors: How do you define Margin of Safety for yourself?

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This is a question to all the senior investors here.

the classic definition is the difference in price vs. the Intrinsic value but so far I have not been able to build conviction around a single number or a range of intrinsic value. Reverse DCF will give an idea of kind of growth expectation and longevity market is assuming .

So how do senior investors feel comfortable with the value of your picks?

  1. do you have a definite intrinsic value range in mind?
  2. or is it going by P/E and growth numbers - a PI industries at 31 PE growing at around 30% is a fair value ? what what is the margin of safety here
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Excellent question.

When we don’t know the exact cost of capital and the long term growth rate, you will get a margin of safety at a fictitious intrinsic value.

In today’s valuation, it is easier to prove the alternate hypothesis - Lot of stocks with no margin of safety.

Stocks with margin of safety today can only be proved with hindsight. After all the crash over the last one year, ITC is trading at 25 + PE in a deflationary FMCG enviroment. In 2003-04, FMCG was trading at 12-15 PE, in a 7% inflation environment. Volume growth was addressing the valuations easily. That’s real margin of safety.

Banks with 8% CAR and 12% stressed advances offer no MoS even at 0.4 times PBV. - Today’s Public sector
Banks with 12% CAR and 9% stressed advances offer no MoS even at 1.5 times PBV. - Private sector

2004
Banks with 12% CAR and 3% stressed advances offered MoS at 1.5 times PBV.

Same in 2008, 2011. Today is no MoS day even after 20% fall.

What it all simply means wait for another day when the market crashes to 14-15 PE. Will that happen? Yes, definitely. That’s the day of guaranteed MoS. You might miss a 60% rally before that. But waiting won’t hurt.

Today’s MoS is telegraphed by yesterday’s value investor and today’s speculator, for their defence. It really does not exist.

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Thank you Sriram !!!

That is a great way to look at the issue. Right now best one could hope for is Great business at fair value.

What it all simply means wait for another day when the market crashes to 14-15 PE. Will that happen? Yes, definitely. That’s the day of guaranteed MoS. You might miss a 60% rally before that. But waiting won’t hurt.

Right now I feel like that in the hunt for good buys.

Every quality stock has had a steep run-up especially during 2014. A 20% correction is not going to drastically change valuations of 10 baggers.

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Yes, Great business at fair value - May be Axis Bank, May be Dr. Reddys, May be ITC. But no one knows.
We don’t know whether businesses will lead the way they are doing. No one questions survival of ITC or Axis Bank. Will they lead or will their businesses become commoditi-zed as we go along? If they are commoditi-zed, there is no pricing power.

We can’t read Graham and Buffett and transfer 70s America opportunity to today’s India.
eg. What retailers learnt the hard way to make private labels over a decade or two, Indian companies are copying it from Day 1.

I know one thing for a bottom - FII should be out, Unique to this rally, MFs have to see redemption. Middle class came to equity big way last year not becos of being negative about real estate / gold or +ve abt equity. They believed in the messiah to fix everything. I admire Mr. Modi for his efforts, but sometimes effort don’t lead to results easily. He is good but he is dealt a bad to average economy. As Buffett says, we know who wins a war of good mgmt and bad business. We will only see average results in the short term. But that will kill the markets as there are still optimists around for 15%-20% earnings growth.

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Sriram, Naik

Valuation and MOS depends on the revenues generated and the cost incurred by the companies. Cost depends on the past performance of the company. The future revenue depends on, well future. Big assumption in those calculations is, that performance of the company will be same with passage of time. Market does not understand this, and if you don’t believe me, read Liar’s poker. Michael Milliken saw the lag between market value vs real value of the companies and monetized it by creating junk bonds. He created many corporate raiders who made a lot of money, but I am digressing.

In order for the cost to remain constant or reduce, the company must be really good at what it is doing. As an Investor, I invest looking at the MOS derived with help of competitive advantages a company has. Also the head winds and tail winds are considered for the particular portfolio of products a company caters to. Tenacity of management do come into picture when discussing cost.
Even though these concepts are intangible, as an investor, we give values to these and then invest. Market does not have time to assign such values, so it reduces the valuation of the companies, blindfolded. Today, we might look at market and say there is MOS, but those very companies, the market punished, are made of men who don’t give up. They find ways to get the bottom of the pyramid to consume.

When you go to the players in the market and try to discuss with them about these concepts, they are bored. Believe me, I have tried. Timing the market is interesting, gambling in the stocks is exhilarating, riding the wave is euphoric. They usually talk about the past conquests and the trades. Being in the now, for them, is quite difficult.

But investing is rather boring and involves lot of reading and being disciplined. It focuses on the NOW. Disciplined to an extent that, if you fix 10K as investment per month, then 10K has to be invested. In that way, the price one gets for a stock gets averaged for that year. When the years pass, the stock rises out of the muddle and starts shining. The returns a stock gives is calculated from the average of those purchase prices.

Many stocks in the past have shined, or we wouldn’t be talking about 2008 & 2011. End of the world bell was ringing so loud, someone saw an opportunity to sell the bell for its metal. Then world came back. Now a new bell has been manufactured, out of surplus commodities out of China and greased by low cost crude, with very long, thick rope made of MFs, EMs and marketing. It is new and very loud, and I hope someone would sell it soon.

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CalMeK, I like your view to feel optimistic about the world. I believe the world gets better every decade, but not necessarily every year, definitely not every month. It can get worse in the short term.

Mike Milken at the end of the day went to jail. If one reads Den of Thieves or Liars Pokers, one will realize those are not great examples. What Seth Klarman (Bio tech start-ups), Ajay Piramal (Vodafone / Reality deals), Rakesh J (Spice Jet) and Buffett (GE / GS / Derivatives) get as value deals are today’s capitalistic opportunism available only to them in recognition of their size. Such deals are not available to you and me. They make their money there to make their averages look super impressive. Their results without these sugar coated deals are still impressive. No doubt. What they got, when they were small and smart as deals in 70s,80s US and 90s India are not easily available today. Markets are more efficient today. May be not in micro caps, but super risks exist there unless you know the management a little more than web research. Some people like Ayush, Donald here do that. But not the average couch investor like me. Market is mostly efficient (or efficient most times) and is inefficient in large caps at most for 4-6 months until new cash comes. That’s when I get an advantage. Mid caps and small caps can remain inefficient for longer periods till large cap rallies.

What is suggested as 10K every month is programmatic investing and not value investing. People have lost their shirts and pants in US from '58 (a mid bottom) to '74 (another mid bottom), while the economy did reasonably ok (don’t want to scare with depression / dot com data as they follow bubbles). Hold forever is a conspiracy by the financial institutions (commission driven) and super rich who can’t sell anyway.

If you look at 2002, 2008, 2011 and their related metrics (past and forward - be it PE, PBV, DCF, EPS Growth rate), it is very different to today. 2008 - EPS expanded by 20% even after the market fell for a few months. It had huge tail wind. Not today. There was one industry 20% weight (IT) generating 30%+ RoI. Not today. 5% growth and redistribution of returns to maintain RoI. Banks had better balance sheet. Not today. Have 2002 NPAs. Midcaps had net cash. Not today. Have Net debt. A 20% fall from the top per se does not make it attractive. Remember earnings have fallen 10% during this time, on an average. An effective fall is only 10%.

My average holding period is 3+ years, Read a lot on value investing etc. Hardcore numbers person, conservative etc. Also worked for a Top 3 capital markets firm in US through the crisis. More importantly I know my limitations as a retail investor. As Charlie Munger says (paraphrased) - “The biggest risk is when you believe your IQ is 150, it is actually 140.”

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Some great posts here! attribute to the quality of the posters here.

Agree that MoS is large the thesis and conviction you can build on a company’s competitive advantage and durability of its Moat. While reading more on this topic I was looking at the role a high ROCE plays in making a company candidate for being one with strong Moat.

This thought process started when realizing that market broadly was fairly priced for quality business. While digging for portfolio candidates instead of trying to discover value pockets I went first hunting for quality business and using ROCE as one of the criteria. I was able to build a watchlist of 100-150 odd businesses using this approach. Next was to apply layer of financial health/leverage, Industry attractiveness, growth prospects, competitive situation and finally valuations. I am right now at a stage where I have a short list of good businesses at fair price. Next step is to go deeper in the businesses and finances and MoS is one part of the puzzle that builds the whole investment case.

Yesterday while specifically looking for how high ROCE can tie into MoS came across great series of posts by John Huber on this blog - http://basehitinvesting.com/

I found his series on ROIC/ROCE particularly useful http://basehitinvesting.com/tag/roic/

In this post http://basehitinvesting.com/importance-of-roic-part-4-the-math-of-compounding/ he illustrates this really well using few examples and numbers.

This definitely gives me a direction going forward. In summary a lot of the learnings is basically what the senior investors here have said above as well as in great threads like Art of Valuation.

Key is to identify compounders that are able re-invest their earnings back at high Returns.

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I believe that margin of safety arises out of mispricing which in turn happens because nearly everyone is shunning the company or hopefully the whole sector. IMO trying to find a margin of safety in well established,well known and well run companies is very tough. (Not saying you can’t it’s just tough).

To me, it’s much harder to say that market is pricing in x% growth but I am confident of 2x% growth (thereby giving me a margin of safety) but I do understand and appreciate the fact that strong growth (an outcome of a wide moat) provides a solid MoS.

Far easier for me is if the market is pricing in essentially negative growth (based on the price) but I suspect the co will last long enough to have at least some growth eventually.

Recent examples

  1. See my VP thread on morepen. Co was selling at lower than 1 P/S ratio when other (no doubt well run) pharma cos we’re at P/S 5 to 7 (importantly, notice how all the responses were extremely negative about the co, such mass negativity is what helps in mispricing)
  2. Capri global around 130 (pre split) where junta was shunning it because of prior issues but the promoter was investing thier own money and not even borrowing it.
  3. Trigyn tech around 35 levels in which thread I said that even if the whole cash on books is fake I’d still be comfortable buying (a statement like that is really margin of safety!)
  4. Indian Toners thread where I could some up the whole thesis in one line and the enterprise value of the co was just three times ebitda (zero debt co).
  5. MOIL around 185 levels was essentially selling for net cash on hand thus giving you the gigantic manganese mines for free!

There are plenty such examples. In each of these cases there was a legitimate reason for investors to dislike cos, but the price was so low that imo a margin of safety was established.

Disc: I’m long on all cos mentioned above, holding from much lower levels. Do your own research

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I am no senior investor but I would like to re-post one of my posts here. Hope this helps.

Let me start this short article with a quote by Charlie Munger:

“No matter how wonderful [a business] is, it’s not worth an infinite price. We have to have a price that makes sense and gives a margin of safety considering the normal vicissitudes of life.”

So, the general principle of margin of safety means that when you are done with your thorough analysis of the company and deciding what the company is current worth for, you further discount it. It acts just as a precaution for any error you could have made in your analysis.

Margin of Safety has been there for a long time and it can be present in any situation. Look at this quote from Warren Buffett:

“You have to have the knowledge to enable you to make a very general estimate about the value of the underlying business. But you do not cut it close. That is what Ben Graham meant by having a margin of safety. You don’t try to buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And that same principle works in investing. “

Here is one more:

“ If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. So, the more vulnerable the business is, assuming you still want to invest in it, the larger margin of safety you’d need. If you’re driving a truck across a bridge that says it holds 10,000 pounds and you’ve got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay, but if it’s over the Grand Canyon, you may feel you want a little larger margin of safety. “

You carrying a power bank when you still think that your phone could survive the day or carrying extra cash to the market as in case you are short on money.

These are some few daily examples where we use the concept of margin of safety.

But use of it in the world of investing was coined by Benjamin Graham in the chapter 20 of his book The Intelligent Investo r. Since then this concept has made investing a little bit stress free for many people.

Okay so the concept seems good but why do you need margin of safety when you think you have done a good analysis?

Here is a tweet from Ian Cassel which answers that for you:

margin of safety

Widening Of The Concept

The world is changing very fast these days. As the technology keeps on getting better day by day.

Everyday we have someone claiming that they have a faster and better way of doing something which the previous technology could not do.

One day the social media market is fully dominated with only one app and suddenly within few months there is a new king.

So when such things are happening around, just getting a safety on the basis of price is not enough. You need more than that which can protect you from permanent capital loss.

That’s when the quality of the business plays a huge role and stands there as a margin of safety for your investment.

This is not something which I have come up with many investors like Prof. Sanjay Bakshi and Vishal Khandewal do use such safety.

Margin of Safety as per Prof. Sanjay Bakshi

For example in article My Email Exchange with Prof. Sanjay Bakshi on Valuations , Prof. Sanjay Bakshi mentions that his valuation method is divided into three stages and each stage provides him with a margin of safety,

First, selecting a quality business which is guarded by a Moat.

Second, being conservative while making assumptions about owner earnings a decade later.

Third, using a exit multiple of well below 20x, even when he knows that business would be worth more than that after a decade.

All these three steps acts as a margin of safety for Prof. Sanjay Bakshi.

Margin of as per Vishal Khandewal

Here are two videos where he talks his view on the concept…

He talks about quality of business as margin of safety from 04:22

Here it starts from 09:33

So, I hope the idea of quality of a business acting as margin of safety is clear.

Here Is What I Do

I try to implement margin of safety into three ways similar to Prof. Sanjay Bakshi:

  1. Being inside my Circle of Competence
  2. Looking for a business with an enduring Moat
  3. At a reasonable valuation which is further discounted at a conservative discount rate.

Let try to understand it again with a small example:

Looking at food consumption business, it is quite far fetched that such industry could be disrupted suddenly.

Even if the technology changes every month it highly unlikely that it would change the way how people consume their food.

Better or newer technology won’t change how people eat or what are their taste preference.(not yet I guess!)

This is one of the reasons why Warren Buffett likes his See’s Candies investment. As faster or better technology wont change the people’s preference for chocolate they most like.

But we need to remember that, business quality alone cannot be a margin of safety, the business must be available at a ‘fair’ valuation.

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Margin of safety from investment standpoint: Acquiring an asset in a staggered manner (up-side or down-side averaging) irrespective of degree of conviction.

Margin of safety from security selection perceptive: Discount at which a security is trading in comparison to fair value. Fair value is a little subjective term and its derivation can vary from one person to another. It is an end-product of quality and growth in an enterprise and can also come down over time. For quality companies, greater the discount to fair value, higher will be margin of safety.

Margin of safety at portfolio level: Investing in a well-diversified basket of quality stocks.

Good Luck.

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