timing is everything

Why?

Because the stock market is a much more complex discounting mechanism. The stock market constantly discounts fundamental data, human psychology and future projections into any given stock price. During this process many errors are possible. It could based on simple misunderstanding of the fundamental data or a negative psychological mood of the overall crowd or due to a market correction/surge. As such, stocks end up being either…..

Significantly Undervalued $25
Undervalued $50
Properly Valued $100
Overpriced $150
Speculatively Overpriced $250

Obviously, as value investors we are interested in the first two categories because such stock give us the best margin of safety. Yet, that doesn’t necessarily mean that the margin of safety you are able to obtain will automatically become your profit margin. For example, if you have bought an “Undervalued” stock at $50 giving you a 50% Margin of safety, it doesn’t mean that the stock will simply appreciate to $100 over a certain period of time so you can sell it at 100% profit. It should, but it doesn’t mean that it will.

Many outcomes are possible here. Yes, if you have done your work right, this particular stock should appreciate to its true value of $100. However, the path it takes is unknown. It could decline even further to $25 before surging back to $100. It can stay at $50 for a couple of years before surging all the way to $250. Should you sell at a $100 or keep the stock in your portfolio due to improving company fundamentals?

As you can see there are way too many possible outcomes here to clearly define if your margin of safety is your profit margin. That is why it is best to look at the Margin of Safety as your insurance policy as opposed to your profit center. The profit or loss that will eventually come from your investment can realize itself in many different ways, yet there is only one Margin Of Safety and it is clearly defined. Now, let’s take a look at a real life margin of safety example and how to apply it to an individual stock.

(*I will keep the analysis very simple here without going into an in-depth analysis and/or valuation work).

Date: 10/18/2013
Company Name: RadioShack Corp (RSH)
Stock Symbol: RSH
Stock Price: $3.35
Market Value: $334 Million
Enterprise Value: $613 Million
Price/Book Ratio: 0.67
Revenue:$ 4.19 Billion
Net Loss: ($206 Million)
Total Cash: $432 Million
Total Debt: $712 Million

A stock that just 3 years ago was selling at close to $25, is now selling at $3.35. That is a about an 85% decline in value for a famous brand name we all know. This type of a situation (significant decline and strong brand name) should definitely peak an interest of a value investor. As mentioned earlier, there could be a million different reasons of why this stock has declined so much, but for the sake of simplicity and our margin of safety discussion lets simply look at how much (if any) margin of safety does this stock offer.

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Margin of safety is one of the most important concepts in value investing and as such deserves a more in depth look and analysis.

As I have mentioned earlier in this book, your margin of safety is the difference between the price you pay for an asset and how much that asset is truly worth. Let’s take a quick look at another example for better understanding.

Imagine a suburban street with 3 identical houses on it. The house on the right sold a few months ago for $500,000 and the house on the left is on the market right now for $520,000. Yet, you are interested in the house in the middle. The previous owner has defaulted on the loan and the house is soon to be auctioned off. Your house is not in as good of a shape as the other two houses. In fact, it has been run down by the previous owner and you estimate that it will cost you about $75,000 to bring it back to the condition of the two adjacent houses.

On the day of the auction you are able to purchase the house for $150,000. With an additional $75,000 in repair costs, your true cost is $225,000. At the same time you know the true value of the house is about $500,000.

So, $500,000-$225,000=$275,000 Is Your Margin Of Safety

By definition, the $275,000 or 55% discount from the true value of the said house becomes your Margin Of Safety. It becomes your safety net to prevent any losses, it becomes your security blanket against adverse developments and it becomes your possible profit margin.

What if it takes $150,000 to fix everything up instead of $75,000. That’s fine you are still in the black. What if you find out that there is an additional $50,000 lean against the house? That’s fine, you are still in the black. Your margin of safety on this house will protect you against various unpleasant developments to the tune of $275,000. Yet, an important question still lingers.

Is the Margin Of Safety your insurance policy or is it your profit margin?

Well, it is both and that is why it is so important when it comes to value investing. First and foremost, margin of safety is your insurance policy. As Warren Buffett so famously said “Investing rule number one…never lose money. Investing rule number two…..never forget rule number one”. Basically, the margin of safety is there to protect you against any losses and unforeseen events.

We live in a complex world where your fundamental analysis will not always be right. You will not always be able to predict unforeseen or as insurance industry calls them “Act Of God Events”. Should such events occur your investment will have a large cushion built into it to protect you against significant losses.

It is only after acting as an insurance policy does Margin Of Safety becomes your profit margin. Technically speaking, your asset should appreciate to its true value. As with the real estate example above your margin of safety of $275,000 becomes your profit if/when you decide to sell the house. Yet, that is not always the case in the stock market. When we deal with publicly traded companies the situation becomes a lot more complex.

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