Everyone loves a bargain.
Value investors are no different. They know that if they buy at a discount they achieve two important objectives. First, they lower their risk of incurring a loss. Second, they increase their potential return when they sell.
Buying at a discount means you need to do your homework and be patient for the right opportunity to come along.
The phrase "margin of safety" was originally coined by Benjamin Graham, the father of value investing. He believed that by building in a margin of safety an investor will reduce the risk of making the wrong investing decision. Value investors believe each stock has two values: the market value and the intrinsic value. The market assigns each asset a value based on supply and demand (its price). But price can deviate from the stock's actual value, which can be deduced by estimating future cash flows and discounting them back to today's dollars.
Since intrinsic value is notoriously difficult to estimate accurately, having a margin of safety provides additional protection for your purchase. If you estimate a stock's intrinsic value as $15, you may decide that to account for miscalculation, you'll only buy if the stock reaches $12. You've built in a $3 margin of safety.
Preserving capital is one of the primary principles of value investing. When you buy a stock at a discount, you take an important step toward reducing the risk that you'll lose capital. Any losses to your investing capital require you to generate a significantly higher return to get back to even.
The riskier the stock, the higher the margin of safety an investor should demand before making a buy. One way to determine an appropriate margin of safety is to remember that owning shares of a company is riskier than owning government bonds. Therefore, the return on a stock should be higher than the rate of return on government bonds.
For example, assume the current yield on 10-year government bonds is 4%. A company you are considering has posted earnings of $1.80 per share and its stock is selling at $20 per share. Its earnings yield (EPS) is 9%. In this case, the stock is generating 5% more in earnings than the ten-year government bond. If you think the company can continue to generate EPS of $1.80 or higher, this might be sufficient margin of safety to justify a purchase of the stock.
The higher the price you pay for a stock, the lower the rate of return you should expect. For example, suppose your analysis indicates that the intrinsic value of a stock is $50. If you pay $75, you are betting that either a) something will happen to significantly increase the stock's intrinsic value, or b) you will find someone else to buy your overvalued stock for more than $75 (often called "the greater fool theory"). Either way, you are taking a significant risk.
A value investor would refuse to buy at $75, and would even refuse to buy at $50. Value investors always want to buy at a discount. If you wait until the price falls to $35 and you're confident the intrinsic value is still $50, you've executed the strategy to perfection. Should the stock return to its intrinsic value of $50, you've just earned yourself a healthy +43% return.
Any time you can buy at a substantial discount, you increase the potential for higher returns. As shown in the table below, when you beat the market by even a small percent, it has a significant impact on your portfolio value over time.
Patience Is a (Profitable) Virtue
Waiting for a bargain takes patience. You do not have to swing at every pitch. If you find yourself unable to wait, step back and review your analysis of the fair value of the company. It helps to get your value investing discipline under control.
Impatient investors who fail to follow their discipline will experience lower returns on their portfolio. Those that keep their emotions in control and wait for the right price experience the better returns
When you buy at a discount, you lower your risk of a mistake and increase the potential of a higher return. While it takes patience, the rewards in the end are worth it.