Margin Of Safety (1)


Benjamin Graham – The Intelligent Investor Summary

Graham focuses on Value Investing. According to Warren Buffet it’s “the best book ever written about investing”.

Book review (by Swedish Investor): https://www.youtube.com/watch?v=npoyc_X5zO8
Book Review (by Financial Freedom): https://www.youtube.com/watch?v=18r2RCVtqTg

Speculation vs. Investment

  • Thorough fundamental analysis in the companies in which you are investing in to promise safety of the principle and adequate return.
  • Protect your assets via diversification
  • Seek stable companies with steady returns
  • Always seek a margin of safety

Develop an understanding of inflation and its impact on your wealth. If inflation is 2.5%, and your bonds / investments are returning 2%, inflation is causing you to lose money each year (0.5%).

Meet Mr. Market. Mr Market is not always rational (often either too optimistic or too pessimistic – bipolar in nature)

  • Be happy to sell when prices are ridiculously high
  • Be happy to buy when Mr Market offers you a bargain

A stock is an ownership interest in a business.

The underlying value of a company does not often equal the price (someone is willing to pay for it).

  • A great company isn’t a great investment if you pay too much for the stock
  • The bigger the firm gets, the slower its growth rate becomes
  • Always be on the lookout for temporary unpopularity; allowing you to buy a great company at a great price

Two types of investors

1. Defensive (passive investor)

    • Portfolio of:
      • 50% stocks (max 75%)  & 50% bonds (min 25%)
        • Rebalance yearly
        • Invest regularly via Dollar cost averaging method
      • Diversify (10 to 30 companies, don’t over expose to certain industries)
      • Invest in only:
        • Large companies > $700m
        • Companies which are conservatively financed (assets are 200% its liabilities – 2 times)
        • Have paid dividends over the last 20 years
        • Have shown profit over the last 10 years (no earnings deficit)
        • At least 33% earnings growth over the last 10 years (equates roughly 2.9% growth annually)
        • Buy company cheap – Market cap less than 1.5 times its net asset value ( i.e.: market cap < (asset – liabilities) x 1.5
        • By cheap earnings – Price to earning ratio (P/E) of less than 15 (i.e P/E < 15)

2. Enterprising (active investor)

  • Need to invest a lot of time, be eager to learn, have patience and discipline
  • In general, avoid growth stocks as the value is based on ‘future earnings’ (may not materialise), rather than looking at a company’s current valuation.
  • If you can find a company where its price is less than its net working capital – you essentially purchase all its fixed assets for nothing
    • Net working capital = current assets – liabilities
  • Portfolio of:
    • Higher returning / higher risk assets
    • Some diversification
    • Invest in any size companies
    • Companies which are less conservatively financed (assets are 150% its liabilities – 1.5 times)
    • Paid a dividend in the last year
    • Growth > 0% (don’t worry about deficits as much)
    • Buy company cheap with tangible assets – Market cap less than 1.2 times its net asset value ( i.e.: market cap < (asset – liabilities) x 1.2

Key Concepts

Stock Valuation Concepts

  • Stock valuation is an art
  • Stock Valuation = Past and Current Numbers + Future Narrative
  • Stock valuation is a range, not an absolute (as its based on assumptions)
    • Plan different scenarios (ie head winds, tail winds etc) and come up with different scenarios and value forecasts (ie ranges)

How to determine Value

Value can be determined by:
  • (Original) Value = earnings per share x (8.5 + 2 x expected annual growth rate)
  • (Updated) Value = ( earnings per share x (8.5 + 2 x expected annual growth rate) x 4.4 ) / current yield on AAA rated corporate bond
  • Grahams value calculation
  • https://en.wikipedia.org/wiki/Benjamin_Graham_formula

Insist on a Margin of Safety (including how to determine value)

  • Mitigates the risk of being wrong (downside protection)
  • Don’t ever lose money
  • When the price is less than two thirds the value, you have a safety margin
    • Price < 2/3 of value (33% safety margin)
  • Graham looks for a 33% safety margin

Insist on Moats

Risk & Reward are not always correlated

  • You don’t have to take a higher risk to achieve a higher reward
  • By committing to deep and time consuming analysis, by exercising maximum intelligence and skill you can find valuable companies to invest in (with low risk)