In my final ship on dealing alongside uncertainty, I brought upward the margin of safety, the tool that many value investors claim to operate to protect themselves against uncertainty. While in that location are for sure unopen to inward the value investing community who receive got works life a expert way to comprise MOS into their investing process, in that location are many to a greater extent than who seem to receive got misconceptions most what it does for them every bit good every bit the merchandise off from using it.
The Margin of Safety: definition together with Rationale
While the margin of security has ever been around, inward i shape or another, inward investing, it was Ben Graham who brought the term into value investing inward The Intelligent Investor, when he argued that the hole-and-corner of audio investment is to receive got a margin of safety, alongside the margin of security defined every bit the divergence betwixt the value of an property together with its price. The definitive mass on MOS was written yesteryear Seth Klarman, a value investing icon. Klarman’s mass has acquired a cult following, partly because of its content together with partly because it has been out of impress straight off for years; a quick depository fiscal establishment check of Amazon indicates a second-hand re-create tin live on acquired for most $1600. Klarman’s guide on margin of security is similar inward spirit to Graham’s measure, alongside an asset-based focus on value, which is captured inward his declaration that investors gain the margin of security yesteryear “buying at a pregnant discount to underlying line of piece of occupation organisation value together with giving preference to tangible assets over intangibles”.
There are many reasons offered for maintaining a margin of safety. The kickoff is that the value of an property is ever measured alongside error together with investors, no thing how good versed they are inward valuation techniques, receive got to recognize that they tin live on incorrect inward their judgments. The instant is that the marketplace toll is determined yesteryear demand together with provide together with if it diverges from value, its pathway dorsum is neither quick nor guaranteed. The proponents of margin of security dot to its benefits. By belongings dorsum on making investment decisions (buy or sell) until y'all experience that y'all receive got a margin of safety, they debate that y'all ameliorate your odds of making successful investments. In addition, They also create the dot that having a salubrious margin of security volition trim back the potential downside on your investments together with assist protect together with save your capital.
The Margin of Safety: Divergence across Investors
As a concept, I non alone empathize the logic of the MOS, but also its allure, together with I am sure that many investors adopt unopen to variant of it inward active investing, but in that location are differences inward how it is employed:
- Valuation Basis: While MOS is oftentimes defined it every bit the divergence betwixt value together with price, the way inward which investors guess value varies widely. The kickoff approach is intrinsic value, either inward its dividend discount model format or a to a greater extent than expansive DCF version. The instant approach estimates value from accounting residual sheets, using either unadjusted mass value or variants thereof (tangible mass value, for instance). The 3rd approach is to operate a pricing multiple (PE, EV to EBITDA), inward conjunction alongside peer grouping pricing, to estimate “a fair price” for the company. While I would contender fifty-fifty calling this publish a value, it is nevertheless used yesteryear many investors every bit their estimated value.
- Magnitude together with Variability: Among investors who operate MOS inward investing, in that location seems to live on no consensus on what constitutes a sufficient margin. Even amid investors who are explicit most their MOS, the follow upward query becomes whether it should live on a constant (say 15% for all investments) or whether it should live on greater for unopen to investments (say inward risky sectors or growth stocks) than for others (utilities or MLPs).
The bottom line is that a room total of investors who all claim to operate margin of security tin contain a grouping alongside vast disagreements on how the MOS is computed, how large it should live on together with whether it should vary across investments together with time.
Myths most Margin of Safety
When talking most value, I am oftentimes challenged yesteryear value investors on how I command for risk together with asked why I don’t explicitly create inward a MOS. Those are fair questions but I do recollect that unopen to of the investors who are most enamored alongside the concept fundamentally misunderstand it. So, at the risk of provoking their wrath, hither is my listing of MOS misconceptions.
Myth 1: Having a MOS is costless
There are unopen to investors who believe that their investment returns volition ever live on improved yesteryear using a margin of security on their investments together with that using a larger margin of security is costless. There are really few actions inward investing that don’t create costs together with benefits together with MOS is non an exception. In fact, the best way to empathize the merchandise off betwixt costs together with benefits is to recollect most type 1 together with type 2 errors inward statistical analysis. If type 1 errors refer to the fact that y'all receive got a imitation positive, type 2 errors reverberate the contrary problem, where y'all receive got a imitation negative. Translating this suggestion into investing, let’s categorize type 1 errors every bit buying an expensive stock, because y'all error it to live on nether valued, together with type 2 errors every bit non buying a bargain-priced stock, because y'all perceive it wrongly to live on over valued. Increasing your MOS volition trim back your type 1 errors but volition increase your type 2 errors.
Many risk averse value investors would guide this merchandise off but in that location is a cost to beingness also conservative together with if that cost exceeds the benefits of beingness careful inward your investment choice, it volition demonstrate upward every bit sub-par returns on your portfolio over extended periods. So, volition using a MOS yield a positive or negative payoff? I cannot respond that query for you, because each investor has to create his or her ain judgment on the question, but in that location are unproblematic tests that y'all tin run on your ain portfolios that volition Pb y'all to the truth (though y'all may non desire to run into it). If y'all notice yourself consistently holding to a greater extent than of your overall portfolio inward cash than your natural risk aversion together with liquidity needs would Pb y'all to, and/or you don't generate plenty returns on your portfolio to crunch what y'all would receive got earned investing passively (in index funds, for instance), your investment process, no thing what its pedigree, is generating internet costs for you. The problems may live on inward whatever of the 3 steps inward the process: your valuations may live on badly off, your judgment on marketplace catalysts tin live on incorrect or y'all may live on using also large a MOS.
Myth 2: If y'all operate a MOS, y'all tin live on sloppy inward your valuations
Value investors who pass all of their fourth dimension coming upward alongside the right MOS together with footling on valuation are doing themselves a disservice. If your valuations are incomplete, badly done or biased, having a MOS on that value volition provide footling protection together with tin alone wound y'all inward the investment procedure (since y'all are creating type 2 errors, without the do goodness of reducing type 1 errors). Given a selection betwixt an investor alongside high character valuations together with no/little MOS together with i alongside poorly done valuations together with a sophisticated MOS, I would guide the old over the latter every unmarried time.
I am also uncomfortable alongside investors who start alongside conservative estimates of value together with thus apply the MOS to that conservative value. In intrinsic valuation, conservative values volition normally hateful haircutting cash flows below expectations, using high discount rates together with non counting inward growth that is uncertain. In asset-based valuation, it tin guide the shape of counting alone unopen to of the assets because they are tangible, liquid or both. Remember that y'all are already double counting risk, when y'all operate MOS, fifty-fifty if your valuation is a fair value (and non a conservative guess of value), because that value is computed on a risk-adjusted basis. If y'all are using a conservative value estimate, y'all may live on triple or fifty-fifty quadruple counting the same risk when making investment decisions. If y'all are using this process, I am amazed that whatever investment manages to arrive through your risk gauntlets to emerge every bit a expert investment, together with it does non surprise me that nada inward the marketplace looks inexpensive to you.
I am also uncomfortable alongside investors who start alongside conservative estimates of value together with thus apply the MOS to that conservative value. In intrinsic valuation, conservative values volition normally hateful haircutting cash flows below expectations, using high discount rates together with non counting inward growth that is uncertain. In asset-based valuation, it tin guide the shape of counting alone unopen to of the assets because they are tangible, liquid or both. Remember that y'all are already double counting risk, when y'all operate MOS, fifty-fifty if your valuation is a fair value (and non a conservative guess of value), because that value is computed on a risk-adjusted basis. If y'all are using a conservative value estimate, y'all may live on triple or fifty-fifty quadruple counting the same risk when making investment decisions. If y'all are using this process, I am amazed that whatever investment manages to arrive through your risk gauntlets to emerge every bit a expert investment, together with it does non surprise me that nada inward the marketplace looks inexpensive to you.
Myth 3: The MOS should live on the same across all investments
I receive got ever been puzzled yesteryear the notion that i MOS fits all investments. How tin a 15% margin of security live on sufficient for both an investment inward a regulated utility every bit good every bit a money-losing start-up? Perhaps, the defence forcefulness that would live on offered is that the investors who operate MOS every bit their risk breakers would non human face at companies similar the latter, but I would nevertheless human face that fifty-fifty inward the value investing spectrum, dissimilar investments would evoke dissimilar degrees of dubiousness (and dissimilar MOS).
Myth 4: The MOS on your portfolio = MOS on private investments inward the portfolio
I know that those who operate MOS are skeptics when it comes to modern portfolio theory, but modern portfolio theory is built on the police trace of large numbers, together with that police trace is robust. Put simply, y'all tin aggregate a large publish of risky investments to create a relatively rubber portfolio, every bit long every bit the risks inward the private stocks are non perfectly correlated. In MOS terms, this would hateful that an investor alongside a concentrated portfolio (who invests inward three, 4 or 5 stocks) would demand a much larger MOS on private investments than i who spreads his or her bets across to a greater extent than investments, sectors together with markets.
Expanding on this point, using a MOS volition create biases inward your portfolio. Using the MOS to pick investment volition thus Pb y'all away from investments that are to a greater extent than exposed to firm-specific risks, which loom large on an private fellowship solid soil but fade inward your portfolio. Thus, biotechnology firms (where the primary risk lies inward an FDA approving process) volition never create your MOS cut, but nutrient processing firms will, for all the incorrect reasons. In the same vein, Valeant together with Volkswagen volition non create your MOS cut, fifty-fifty though the risk y'all confront on either stock volition live on lowered if they are parts of larger portfolios.
Expanding on this point, using a MOS volition create biases inward your portfolio. Using the MOS to pick investment volition thus Pb y'all away from investments that are to a greater extent than exposed to firm-specific risks, which loom large on an private fellowship solid soil but fade inward your portfolio. Thus, biotechnology firms (where the primary risk lies inward an FDA approving process) volition never create your MOS cut, but nutrient processing firms will, for all the incorrect reasons. In the same vein, Valeant together with Volkswagen volition non create your MOS cut, fifty-fifty though the risk y'all confront on either stock volition live on lowered if they are parts of larger portfolios.
Myth 5: The MOS is an choice risk measure
I know that many investors loathe betas, together with believe it or not, I understand. In fact, I receive got long argued that in that location are replacements available for portfolio theory-based risk measures together with that non alone is intrinsic value robust plenty to piece of occupation alongside these choice risk measures but that the discount charge per unit of measurement is non (and should not) live on the ultimate driver of value inward most companies. That said, in that location are unopen to inward the value investing community who similar to operate their dislike of betas every bit a bludgeon against all fiscal theory together with afterward they receive got beaten that straw Equus caballus to death, they volition offering MOS every bit their choice risk measure. That suggests a telephone commutation misunderstanding of MOS. To operate MOS, y'all demand an guess of value together with I am non aware of whatever intrinsic value model that does non require a risk adjustment to instruct to value. In other words, MOS is non an choice to whatever existing risk mensurate used inward valuation but an add-on, a way inward which risk averse investors tin add together a instant layer of risk protection.
There is i possible way inward which the MOS may live on your primary risk adjustment machinery together with that is if y'all operate a constant discount charge per unit of measurement when doing valuation (a cost of upper-case alphabetic character of 8% for all companies or fifty-fifty a risk release rate) together with thus apply a MOS to that valuation to capture risk. If that is your approach, y'all should definitely live on using dissimilar MOS for dissimilar investments (see Myth 3), alongside a larger MOS beingness used on riskier investments. I would also live on curious most how precisely y'all create this MOS adjustment for risk, including what risks y'all guide inward together with how y'all create the conversion.
There is i possible way inward which the MOS may live on your primary risk adjustment machinery together with that is if y'all operate a constant discount charge per unit of measurement when doing valuation (a cost of upper-case alphabetic character of 8% for all companies or fifty-fifty a risk release rate) together with thus apply a MOS to that valuation to capture risk. If that is your approach, y'all should definitely live on using dissimilar MOS for dissimilar investments (see Myth 3), alongside a larger MOS beingness used on riskier investments. I would also live on curious most how precisely y'all create this MOS adjustment for risk, including what risks y'all guide inward together with how y'all create the conversion.
Margin of Safety – Incorporating into a Strategy
I would non set myself inward the MOS army camp but I recognize its operate inward investing together with believe that it tin live on incorporated into a expert investing strategy. To do so, though, y'all would demand to do the following:
- Self examination: Even if y'all believe that MOS is a expert way of picking investments, it is non for everyone. Before y'all adopt it, y'all receive got to assess non alone your ain standing (including how much y'all receive got to invest, how risk averse y'all are) but also your organized religious belief (in your valuation prowess together with that markets right their mistakes). Once y'all receive got adopted it, y'all nevertheless demand the effects it has on your portfolio, including how oftentimes y'all guide non to invest (and grip cash instead) together with whether it makes a fabric divergence to the returns y'all generate on your portfolio.
- Sound Value Judgments: As I noted inward the final section, a MOS is useful alone if it is an addendum to audio valuations. This may live on a reflection of my biases but I believe that this requires intrinsic valuation, though I am willing to concede that in that location are multiple ways of doing it right. Accounting valuations seem to live on built on the twin presumptions that mass value is an approximation of liquidation value together with that accounting fair value truly agency what it says, together with I receive got footling organized religious belief inward either. As for passing of pricing every bit value, it strikes me every bit inconsistent to operate the marketplace to instruct your pricing publish (by using multiples together with comparable firms) together with thus debate that the same marketplace misprices the property inward question.
- A Flexible MOS: Tailor the MOS to the investment that y'all are looking at: There are ii reasons for using a MOS inward the kickoff place. The kickoff is an credence that, no thing how difficult y'all try, your guess of value tin live on incorrect together with the instant is that fifty-fifty if the value guess is right, in that location is dubiousness most whether the marketplace volition right its mistakes over your fourth dimension horizon. If y'all purchase into these ii reasons, it follows that your MOS should vary across investments, alongside the next determinants.
- Valuation Uncertainty: The to a greater extent than uncertain y'all are most your estimated value for an asset, other things remaining equal, the larger the MOS should be. Thus, y'all should operate a smaller MOS when investing inward mature businesses together with during stable markets, than when putting your coin inward young, riskier line of piece of occupation organisation or inward markets inward crises.
- Portfolio Tailoring: The MOS that y'all operate should also live on tailored to your portfolio choices. If y'all are a concentrated investor, who invests inward a 4 or 5 companies, y'all should operate a much higher MOS than an investor who has a to a greater extent than diversified portfolio, together with if y'all the latter, maybe fifty-fifty modify the MOS to live on larger for companies that are exposed to macroeconomic risks (interest rates, inflation, commodity prices or economical cycles) than to company-specific risks (regulatory approval, legal jeopardy, management flux).
- Market Efficiency: I know that these are fighting words to an active investor, ruddy flags that telephone telephone forth intemperate responses. The truth, though, is that fifty-fifty the most rabid critics of marketplace efficiency ultimately believe inward their ain versions of marketplace efficiency, since if markets never corrected their mistakes, y'all would never create coin of fifty-fifty your canniest investments. Consequently, y'all should settle for a smaller MOS when investing inward stocks inward markets that y'all perceive to live on to a greater extent than liquid together with efficient than inward assets, where the corrections volition presumably come about to a greater extent than apace than inward inefficient, illiquid markets where the hold back tin live on longer.
- Pricing Catalysts: Since y'all create coin from the toll adjusting to value, the presence of catalysts that tin Pb to this adjustment volition allow y'all to settle for a lower MOS. Thus, if y'all believe that a stock has been mispriced ahead of an earnings report, a regulatory finding or a legal judgment, y'all should demand a lower MOS than when y'all invest inward a stock that y'all believe is misvalued but alongside no obvious pricing catalyst inward sight.
Conclusion
Would I prefer to purchase a stock at a 50% discount on value rather than at just below fair value? Of course, together with I would live on fifty-fifty happier if y'all made that a 75% discount. Would I experience fifty-fifty to a greater extent than comfortable if y'all estimated value really conservatively. Yes together with I would live on delighted if all y'all counted was liquid assets. That said, I don't alive inward a world where I run into also many of these investments together with when I do, it is normally the front end for a scam rather than a legitimate bargain. That is the ground that I receive got never formally used a MOS inward investing. I did purchase Valeant at $32, because my valuation of the stock yielded $45 for the company. Would I receive got nevertheless bought the stock, if my value guess had been alone $35 or if it was a large chunk of my portfolio? Perhaps not, but I receive got bought stocks that were priced at my estimated fair value together with receive got held dorsum on investments that I receive got works life to live on nether valued yesteryear 25% or more. Why? That has to hold back for my coming ship on simulations, since this i has run its course.
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Uncertainty Posts
YouTube Video
Uncertainty Posts
- DCF Myth 3: You cannot do a valuation, when in that location is also much uncertainty
- The Margin of Safety: Excuse for Inaction or Tool for Action?
- Facing upward to Uncertainty: Probabilities together with Simulations
DCF Myth Posts
Introductory Post: DCF Valuations: Academic Exercise, Sales Pitch or Investor Tool
- If y'all receive got a D(discount rate) together with a CF (cash flow), y'all receive got a DCF.
- A DCF is an practise inward modeling & publish crunching.
- You cannot do a DCF when in that location is also much uncertainty.
- It's all most D inward the DCF (Myths 4.1, 4.2, 4.3, 4.4 & 4.5)
- The Terminal Value: Elephant inward the Room! (Myths 5.1, 5.2, 5.3, 5.4 & 5.5)
- A DCF requires also many assumptions together with tin live on manipulated to yield whatever value y'all want.
- A DCF cannot value create nurture or other intangibles.
- A DCF yields a conservative guess of value.
- If your DCF value changes significantly over time, in that location is something incorrect alongside your valuation.
- A DCF is an academic exercise.
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