How to Invest Wisely with the Margin of Safety Principle.
Investing is a matter that should not be taken lightly. The benefits of investing will only come to those who are serious about it. A serious investor is someone who understands the fundamental principles of investing and works hard to apply them to grow their wealth. This wealth should be long-lasting and the growth of it should be real, sustainable, durable, and superior.
Many people see the stock market as an easy way to make some quick money. This frivolous attitude towards a fair system for creating wealth is unfortunate. However, this post targets serious investors who understand the value of investing in the stock market. These investors are in the minority, and since you are reading this post, you are likely one of them.
One of the most important qualities of a serious investor is being knowledgeable about the fundamental principles of investing. There are numerous investing principles, and in this post, I would like to discuss a significant one – ‘the margin of safety’ principle.
A diligent investor needs to do two things: firstly, collect accurate and useful information about a stock; and secondly, interpret this information to understand its significance on the stock’s investment prospects. For successful investing, both are important: having authentic information and the ability to interpret it to understand its market significance.
However, an experienced investor knows that being too earnest and overconfident can lead to poor decisions with disastrous consequences. The economy and markets are complex and dynamic systems where millions of people interact in many ways. It is beyond the capacity of any single person or group to fully understand them.
Fortunately, there is a concept that can help investors navigate the vagaries of the stock market successfully: It is the ‘Margin of Safety’ principle.
The margin of safety principle states that you should buy stocks only when there is a sufficient gap between the stock’s market price and its intrinsic value. The gap should be sufficient to absorb any potential shocks caused by the market’s unpredictability. Benjamin Graham’s book ‘The Intelligent Investor‘ recommends purchasing stocks at a 30 percent discount to their intrinsic value. For instance, if a stock has an intrinsic value of ₹100 per share, you should buy it only at ₹70 per share or lower. The difference between the intrinsic value and the market price, which is ₹30 in this case, is the margin of safety.
Let’s apply the concept to the stock of ‘Dhanuka Agritech’, which is an agrochemical company. Our basic valuation suggests that the stock’s intrinsic value is around 2.72 times its book value, which is ₹709.25 per share. To buy the stock with a 25 percent margin of safety, our purchase price should be ₹568 per share or less. However, the current market price of the stock is ₹970 per share, which is a 37 percent premium to the intrinsic value and a 71 percent premium to our purchase price. Therefore, buying the stock now would be too risky from a margin of safety perspective.
The concept could be applied to the general market too. The 10-year India Govt. bond yields 7.26 percent now, while the earnings yield of Nifty50 is 4.48 percent: this means Nifty50 is valued at a 62 percent premium over the 10-year GOI bond. Stock earnings usually command a premium valuation over bond earnings because of the growth potential of stock earnings, whereas bond earnings mostly remain unchanged over their lifetime. However, I consider 50 percent as a fair premium between Nifty50 earnings yield and 10-year GOI bond yields. Any premium above 50 percent means stocks have entered the overvaluation territory and a premium below 50 percent means stocks are fairly valued. A 25 percent or less premium means the stock market has become attractive. Therefore, the current stock market is not a buyers’ market due to the 62 percent premium between earnings yield and bond yield.
How does the margin of safety concept apply to this situation? If we consider 50 percent as a fair premium between earnings and bond yield, then at a bond yield of 7.26 percent, a fair earnings yield would be 4.84 percent. At this yield, the Nifty50 should be trading at 19,360. If we apply a margin of safety of 25 percent, the corresponding Nifty50 value is 15,488. It is not necessary to demand a margin of safety for the general market at the same scale as individual stocks: a 5 percent or 10 percent margin of safety from the fair value will provide satisfactory protection against market risks.
The margin of safety serves as a protective barrier for your investment portfolio in a world of endless possibilities where things can go wrong in numerous ways. By purchasing stocks at a price that provides an adequate margin of safety, you are making sure that in case something goes amiss, the resulting damage or capital loss, if any, is kept to a minimum.
AMN CAPITAL 