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FINANCIAL CHRONICLE™ » FINANCIAL CHRONICLE™ » The 3 Most Important Words In Investing

The 3 Most Important Words In Investing

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1The 3 Most Important Words In Investing Empty The 3 Most Important Words In Investing Fri Feb 24, 2012 5:00 am

sriranga

sriranga
Co-Admin
Written by Graham, and endorsed by Buffett and Klarman.
Today I take a look at Chapter 20 of Ben Graham's The Intelligent Investor, entitled 'Margin of Safety'.
Seth Klarman considered this chapter so important that he took 'Margin of Safety' as the title for his famous and much sought-after book.

Making the future irrelevant
The main point of this chapter is that we must always buy with a margin of safety. If we get the assets cheaply enough, then we are already protected against future earnings disappointments.

"Here the function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future. If the margin is a large one, then it is enough to assume that future earnings will not fall far below those of the past in order for an investor to feel sufficiently protected against the vicissitudes of time."
Graham is referring in this quote to bonds, but goes on to extend the idea to shares.

Buy quality
According to Graham, buying low-quality assets in the boom times is a greater risk than overpaying for a high-quality asset:
"However, the risk of paying too high a price for good-quality stocks -- while a real one -- is not the chief hazard confronting the average buyer of securities. Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favourable business conditions."

"Thus it follows that most of the fair-weather investments, acquired at fair-weather prices, are destined to suffer disturbing price declines when the horizon clouds over -- and often sooner than that."

Future projections
In trying to assess the margin of safety in an investment, we can look at how reliable the earnings estimates have been in the past, or we can do a detailed analysis of future earnings. At the time of writing, the latter method was gaining popularity, but the danger is that analysts are too bullish in their estimates of the future.
Investors are more likely to find a margin of safety in shares that are out of favour with the market.

"If these are bought on a bargain basis, even a moderate decline in the earning power need not prevent the investment from showing satisfactory results. The margin of safety will then have served its proper purpose."

Eggs and baskets
"Even with a margin in the investor's favour, an individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss -- not that loss is impossible."

For that reason, we need to spread our risk, and that means buying a portfolio of suitable shares so the we are protected from a collapse in any specific share.

Speculators and investors
Coming back to the distinction between speculating and investing, Graham suggests that the margin-of-safety concept may be used to distinguish a true investment from a speculative venture.

"We greatly doubt whether the man who stakes money on his view that the market is heading up or down can ever be said to be protected by a margin of safety in any useful sense of the phrase."

"Thus, in sum, we say that to have a true investment there must be present a true margin of safety. And a true margin of safety is one that can be demonstrated by figures, by persuasive reasoning, and by reference to a body of actual experience."


What is quality?
Quality should not be confused with size or type of business. As Jason Zweig says:
"there is no such thing as a good or bad stock; there are only cheap stocks and expensive stocks. Even the best company becomes a "sell" when its stock price goes too high, while the worst company is worth buying if its stock goes low enough."

Four principles
"Investment is most intelligent when it is most businesslike", says Graham. And to help make it more businesslike, he spells out four principles that 'intelligent investors' should follow:

* Know what you are doing -- know your business;

* Do not let anyone else run your business, unless (1) you can supervise his performance with adequate care and comprehension or (2) you have unusually strong reasons for placing implicit confidence in his integrity and ability;

* Do not enter upon an operation unless a reliable calculation shows that it has a fair chance to yield a reasonable profit; and

* Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it -- even though others may hesitate or differ.

As Graham says: "To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks."

Edited Article BY Padraig O'Hannelly
http://www.fool.co.uk/news/investing/2012/02/23/the-3-most-important-words-in-investing.aspx

http://sharemarket-srilanka.blogspot.co.uk/

Kumar

Kumar
Senior Vice President - Equity Analytics
Senior Vice President - Equity Analytics
Worth to read.

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