Tuesday, July 12, 2011

Margin of Safety

"A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world." Seth Klarman

By far the most effective behavioural finance strategy which is highly recommended by many investment gurus is value investing. The virtue of value investing is that investors buy at prices that are already low, so there isn’t much room for further down play. I would like to introduce to you our "Father of Value Investing" - Benjamin Graham.

Benjamin Graham
Benjamin Graham, born in 1894 witnessed the devastation of the 1929 crash and has since developed resilient techniques that could be used by any investor. He popularized the examination of price-earning (PE) ratios, debt-to-equity ratios, dividend records, net current assets, book values and earnings growth. That earned him the name of the “Father of Value Investing”. He brilliantly concocted the ‘Margin of Safety” theory that has gained tremendous support across the finance industry. Graham defined margin of safety as the margin at which a stock can be purchased with minimum downside risk.

There are many criteria for Graham’s margin of safety investment approach, the most stringent is this: Purchase the stock with price not more than two-thirds of Net Current Asset Value (NCAV).

How to calculate the NCAV?

Net Current Asset Valuation (NCAV) is computed by total current assets less total liabilities.

Example – Calculation for NCAV
Cash at bank 200
Debtors 100
Inventory 100

Total Liabilities 200
# of shares 100

Share price 1.80

In the example, given that the total current assets are RM400,000 and total liabilities are RM200,000, the net current asset per share is RM2 which is lower than the current market price. However, it is still not good enough as according to Graham’s criteria, the purchase price must not be more than two-thirds of the NCAV which is RM1.33. Therefore, we will not purchase the stock.

The margin of safety for this case is 26% (the difference between current market price and the conservative calculation using Graham’s criteria) which is lower than the minimum margin of safety of 33%. Buying at steep discount using the margin of safety approach can help to cushion the negative surprises in the financial market.

The above theory looks nice in theory but it is not very practical in the modern world now. Using this method, I can't find any good bargain because most of the companies have more debt than their current assets. But this method does screen out those companies with solid cash position in their balance sheet. Perhaps, we can improvise the strategy a little, rather than 2/3 of NCAV, maybe we can multiply the NCAV by 2 or 3 times instead.

Happy investing,
Pauline Yong


twc said...

Your "Margin of Safety", "Herd Mentality","Over-confidence" and the ability to predict in addition to predict beside knowledge and skill of analysis like your dad are excellent articles every investor would benefit, I believe, by reading and digesting them! Thank you for sharing Pauline.
Chiam Tah Wen

Pauline Yong said...