"Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety."
– The Intelligent Investor, Chapter 20, Benjamin Graham
"Good warriors prevail when it is easy to prevail. "
- The Art of War, Sun Tzu
In this post, and in the following two after it, I will discuss the ideas behind what is probably the most central concept in the Value Investing discipline: the 'Margin of Safety'. Benjamin Graham, the 'Father of Value Investing' introduced it to the investing world in his book, The Intelligent Investor.
Simply explained, the Margin of Safety principle demands that investors only invest in businesses or stocks that trade at a significant discount to their calculated 'true value'. This 'true value' is also called the 'intrinsic value'. In other words, if you calculate a stock's intrinsic value to be $100, you should give yourself a 'margin of safety' and only pay, say $70 or less for it. Makes sense, right? This is no different to when you go shopping at the supermarket: Pasta, which normally sells for $2 a pack is now on special, and priced at $1. You wouldn't think twice (unless of course you're allergic to pasta or the expiry date is way passed today's). Savvy shoppers will take advantage when items are on sale, and buy in bulk.
All this sounds like common sense, but I bet you're dying to ask the following questions:
(1) Does the price of a business or stock ever trade at a significant discount or premium to their true or intrinsic value? If so, why?
(2) How Do I Calculate the True (Intrinsic) Value of a Stock?
(3) Why Not Pay the Fair Value for a business? Why Must I seek a Margin of Safety?
(4) How great a Margin of Safety do Value Investors generally demand?
(5) Isn’t it possible that the reason the price of a stock is so cheap is because the company is poorly managed, is not profitable or is a high-risk business?
"Good warriors prevail when it is easy to prevail. "
- The Art of War, Sun Tzu
In this post, and in the following two after it, I will discuss the ideas behind what is probably the most central concept in the Value Investing discipline: the 'Margin of Safety'. Benjamin Graham, the 'Father of Value Investing' introduced it to the investing world in his book, The Intelligent Investor.
Simply explained, the Margin of Safety principle demands that investors only invest in businesses or stocks that trade at a significant discount to their calculated 'true value'. This 'true value' is also called the 'intrinsic value'. In other words, if you calculate a stock's intrinsic value to be $100, you should give yourself a 'margin of safety' and only pay, say $70 or less for it. Makes sense, right? This is no different to when you go shopping at the supermarket: Pasta, which normally sells for $2 a pack is now on special, and priced at $1. You wouldn't think twice (unless of course you're allergic to pasta or the expiry date is way passed today's). Savvy shoppers will take advantage when items are on sale, and buy in bulk.
All this sounds like common sense, but I bet you're dying to ask the following questions:
(1) Does the price of a business or stock ever trade at a significant discount or premium to their true or intrinsic value? If so, why?
(2) How Do I Calculate the True (Intrinsic) Value of a Stock?
(3) Why Not Pay the Fair Value for a business? Why Must I seek a Margin of Safety?
(4) How great a Margin of Safety do Value Investors generally demand?
(5) Isn’t it possible that the reason the price of a stock is so cheap is because the company is poorly managed, is not profitable or is a high-risk business?
In this post I'm going to answer only the first question. The others will be dealt with in the coming posts.
Q1. Does the price of a business or stock ever trade at a significant discount or premium to their true or intrinsic value? If so, why?
A1: Yes – all the time. Don't believe me? Open any newspaper, or financial website (Yahoo will do), pick any major public company and look at the 52-week high and 52-week low. Let's look at Teva (TEVA). The 52-week low was $30.70, pricing the entire business at around $23.39 billion. (To calculate the value of the entire business, mutliply the no. of shares that are outstanding by the share price). The 52-week high is $45.44, pricing the entire business at $34.62 billion. That's a huge spread – a little over $11 billion. How can this be? Which is the correct and fair price? Can a business change so significantly that it will have gained or lost $11 billion in value in the space of a year? The answer to all this is simply this: the market does not always behave rationally. Why not?
Two reasons that may explain this are:
(i) The market is sometimes driven by the emotions of greed and fear. For example, when an individual invests in a company without really researching it, because he heard from a neighbor that he made several thousand dollars from a stock that shot up 20%. That's not rational - it's insane. Imagine being told that the price of bread increased by 20% at a certain bakery. You wouldn't feel the sudden need to rush out and buy bread from that bakery. You'd look elsewhere for a better deal. Most people however, behave differently when it comes to the stock market. When hearing a stock or fund has increased by a huge amount, they feel that they are going to miss out on the profits and buy after the stock is has already increased in prive. That's greed talking. My neighbor, however, is smarter than that. If I tell him that I bought SanDisk at $37, and it drops to $36, he understands that he can get a better deal than what I got, and he calls his broker. Just like buying pasta on special at the supermarket. Right, Oren?
In Robert Hagstrom's, The Warren Buffett Way, (see also this post) he explains that the Value Investing methodology developed by Graham was based on the belief that the market is often wrong:
"Graham's conviction rested on certain assumptions. First, he believed that the market frequently mispriced stocks. This mispricing was most often caused by human emotions of fear and greed. At the height of optimism, greed moved stocks beyond their intrinsic value, creating an overpriced market. At other times, fear moved prices below intrinsic value, creating an undervalued market."
(ii) The market forgets that stocks are fractional bits of actual companies. Some individuals think of stocks as bits of paper that are traded back and forth. They rarely consider the business behind the stock - the products or services, the clients or employees. As Benjamin Graham wrote in Security Analysis in 1934:
"It is an almost unbelievable fact that Wall Street never asks: 'How much is the business selling for? Yet this should be the first question in considering a stock purchase."
(i) The market is sometimes driven by the emotions of greed and fear. For example, when an individual invests in a company without really researching it, because he heard from a neighbor that he made several thousand dollars from a stock that shot up 20%. That's not rational - it's insane. Imagine being told that the price of bread increased by 20% at a certain bakery. You wouldn't feel the sudden need to rush out and buy bread from that bakery. You'd look elsewhere for a better deal. Most people however, behave differently when it comes to the stock market. When hearing a stock or fund has increased by a huge amount, they feel that they are going to miss out on the profits and buy after the stock is has already increased in prive. That's greed talking. My neighbor, however, is smarter than that. If I tell him that I bought SanDisk at $37, and it drops to $36, he understands that he can get a better deal than what I got, and he calls his broker. Just like buying pasta on special at the supermarket. Right, Oren?
In Robert Hagstrom's, The Warren Buffett Way, (see also this post) he explains that the Value Investing methodology developed by Graham was based on the belief that the market is often wrong:
"Graham's conviction rested on certain assumptions. First, he believed that the market frequently mispriced stocks. This mispricing was most often caused by human emotions of fear and greed. At the height of optimism, greed moved stocks beyond their intrinsic value, creating an overpriced market. At other times, fear moved prices below intrinsic value, creating an undervalued market."
(ii) The market forgets that stocks are fractional bits of actual companies. Some individuals think of stocks as bits of paper that are traded back and forth. They rarely consider the business behind the stock - the products or services, the clients or employees. As Benjamin Graham wrote in Security Analysis in 1934:
"It is an almost unbelievable fact that Wall Street never asks: 'How much is the business selling for? Yet this should be the first question in considering a stock purchase."
"Why Both Bulls and Bears Can Act So Bird-Brained" - a New York Times article written a decade ago explores this in some depth. You can view it here.
So I think it's just about now where we learn the first Value Investing Mantra.
Repeat after me:
"The Price of a stock is not the same as the Value of a stock"
Most investors do not understand this principle, which explains why the market crowd is very often emotionally-driven, and does not behave rationally.
Value Investors focus on the Value of the business, not on the price of it.
As Warren Buffett famously declared: "Price is what you pay, value is what you get."
In the next posts I will continue our discussion on Margin of Safety and look at how intrinsic value is calculated, why you must seek a Margin of Safety, and how great a Margin of Safety is required. I will also briefly discuss 'Value Traps'.
Until next time - May you possess the Wisdom to See what the market does not, and the Courage to act on it.
Repeat after me:
"The Price of a stock is not the same as the Value of a stock"
Most investors do not understand this principle, which explains why the market crowd is very often emotionally-driven, and does not behave rationally.
Value Investors focus on the Value of the business, not on the price of it.
As Warren Buffett famously declared: "Price is what you pay, value is what you get."
In the next posts I will continue our discussion on Margin of Safety and look at how intrinsic value is calculated, why you must seek a Margin of Safety, and how great a Margin of Safety is required. I will also briefly discuss 'Value Traps'.
Until next time - May you possess the Wisdom to See what the market does not, and the Courage to act on it.
2 comments:
Very nice post Avi, even though you choosed to answer first to the easiest question. Eagerly waiting for your other answers.
Shabat shalom.
Hi Arnon,
I'm glad you enjoyed the post. Thanks for letting me know.
Yes - the first question is the easiest. I feel that it needs to dealt with first because understanding it is a pre-requisite to understanding the answers of the others.
I look forward to your continued input and thoughts.
Shabbat Shalom.
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