Margin of Safety

1
Margin of Safety

• A favorable difference between price on the one
  hand and appraised value on the other
• The Cost of Paying Too Much
• To achieve satisfactory investment results is
  easier than most people realize to achieve
  superior results is harder than it looks

2
The Earnings Power

• The margin of safety lies in an expected earning
  power considerably above the going rate for
  bonds.
• Coverage of interest charges must be tested over
  a number of years, including preferably a period
  of subnormal business.
• Economic value added (EVA) measures the earning
  powers incorporating opportunity cost of capital
  invested.

3
Risk of Estimating Earnings Power

• The risk of paying too high a price for
  good-quality stocks
• The risk of purchasing low-quality stocks at
  times of favorable business conditions
• The risk of growth stocks assuming that expected
  earnings power is higher than the average of
  shown in the past

4
The Earnings Yield

• Assume that the earning yield is 9 on the stock
  price and that the bond yield is 4
• The stockbuyer will have an average annual margin
  of 5 accruing in his favor
• Some of the excess is paid in the dividend
• The undistributed balance is reinvested in the
  business for his account
• In many cases, such reinvested earnings fail to
  add commensurately to the earning power and the
  value of his stock

5
The Earnings Yield

• Over a 10-year period, the typical excess of
  stock earnings power over bond interest may
  aggregate 50 of the price paid
• Is this figure sufficient to provide a very real
  margin of safety, which under favorable
  conditions will prevent or minimize a loss?
• If such a margin is present in each of
  diversified list of 20 or more stocks,
• the probability of a favorable result under
  fairly normal conditions becomes very large.

6
Margin of Safety Investing

• The policy of investing in representative stocks
  with high margin of safety
• (earning yield minus bond yield)
• If stock purchases are made at the average level
  of the market over a span of years, the prices
  paid should carry with the assurance of an
  adequate margin of safety
• The danger to investors lies in concentrating
  their purchases in the upper levels of the market
• Or in buying non-representative stocks that carry
  more than average risk of diminished earnings
  power

7
Margin of Safety and Diversification

• Even with a margin of safety in the investors
  favor, an individual security may work out badly.
• For the margin guarantees only that he has better
  chance for profit than for loss---not that loss
  is impossible.
• As the number of such commitments is increased
  the more certain does it become that the
  aggregate of the profits will exceed the
  aggregate of the losses.
• This is the simple basis of the
  insurance-underwriting business.

8
Sum Up

• Investment is most intelligent when it is most
  businesslike.
• Every corporate security may be best viewed as an
  ownership interest in a specific business
  enterprise.
• If a person sets out to make profits from
  security purchases and sales, he is embarking on
  a business venture of his own, which must be run
  in accordance with accepted business principles
  if it is to have a chance of success.

9
Four Business Principles

• Know what you are doing-know your business.
• Do not try to make business profits out of
  securities,
• that is, returns in excess of normal interest
  and dividend income,
• unless you know as much about security values
  as you would need to know about the value of
  merchandise that you proposed to manufacture or
  deal in.

10
Four Business Principles

• Don 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.
• For the investor,
• this rule should determine the conditions
  under which he will permit someone else to decide
  what is done with his money.

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Four Business Principles

• Do not enter upon an operation, that is,
  manufacturing or trading in an item, unless a
  reliable calculation shows that it has a fair
  chance to yield a reasonable profit.
• Keep away from ventures in which you have little
  to gain and much to lose.
• For the enterprising investor, this means that
  his operations for profits should be based not on
  optimism but on arithmetic.

12
Four Business Principles

• 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.
• You are neither right nor wrong because the crowd
  disagrees with you.
• You are right because your data and reasoning are
  right.
• In the world of security, courage becomes the
  supreme virtue after adequate knowledge and a
  tested judgment are at hand.

13
Dont Buy Overpriced Good Companies

• There is no such thing as a good or bad stock but
  there is only cheap stocks and expensive stocks.
• Even the high-grade company becomes a sell when
  its stock price goes too high, while a
  medium-grade company is worth buying if its stock
  price goes low enough to create a substantial
  margin of safety.

14
A overpriced good company is a bad investment

• Imagine that you find a stock that you think can
  grow at 10 a year even if the market only grow
  5 annually.
• Unfortunately, you are so enthusiastic that you
  pay too high a price, and the stock loses 50 of
  its price the first year.
• Even if the stock then generate double the
  markets return, it will take you more than 16
  years to overtake the marketsimply because you
  paid too much at the outset.

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Overconfident Investors

• Financial risk resides not in what kinds of
  investment you have, but in what kind of investor
  you are.
• Take credit for your gain and blame others for
  you loss.
• Making profits increases investors
  overconfidence, and consequent they trade more
  aggressively in next periods.
• A question
• The Dow Jones Industrial Average closed at 9181
  in 1998. As a price index, the DJIA does not
  include reinvested dividends. If the DJIA
  redefined to reflect the reinvestment of all
  dividends since May 1896, when it commenced at a
  value of 40, what would its value have been at
  the end of 1998?

17
A Noble-Prize Winner Daniel Kahneman

• Kahneman explains two factors that characterize
  good decisions
• Well-calibrated confidence do I understand this
  investment as well as I think I do?
• Correctly-anticipated regret how will I react if
  my analysis turns out to be wrong?
• Before you invest, you must ensure that you have
  realistically assessed your probability of being
  right and how you will react to consequences of
  being wrong.

18
Prospect Theory

• Prospect theory
• (the prospect of a loss or gain)
• is a descriptive framework for the way people
  make choices in the face of risk and uncertainty.
• Suppose that you face a choice between
• (1) Accepting a sure loss of 7,500, or
• (2) taking a chance where there is a 75
  chance you will lose 10,000 and a 25 chance you
  will lose nothing.

19
Prospect Theory and Loss Aversion

• People sell the winners too soon and hold the
  losers too long.
• (the changing utility function with the
  concave curve in profit and the convex curve in
  loss)
• The get-evenitis disease
• People do not sell anything at a loss and want
  to get even before they get out

20
A Kahneman-Tversky Concurrent Decision

• Imagine that you face following pair of
  concurrent decisions. First examine both sets of
  choices, then indicate the option you prefer for
  each
• First decision Choose
• A. a sure gain of 2,400
• B. a 25 chance to gain 10,000 and a 75
  chance to gain nothing.
• Second decision Choice
• C. a sure loss 0f 7,500
• D. a 75 chance to lose 10,000 and a 25
  chance to lose nothing.

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Decision Frame in Concurrent Decisions

• Suppose that you face a choice
• you can take
• (Tom) take a 75 chance you will lose 7,600
• and a 25 chance you will win
  2,400
• (Mary) you can take the same chance and
• accept an additional 100.
• A no-brainer?
• The decision frame is transparent.

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Opaque Decision frame

• People who choose AD, end up facing a 75 chance
  of losing 7,600 and a 25 chance of winning
  2,400.
• People who choose BC, end up facing a 75 chance
  of losing 7,500 and a 25 chance of winning
  2,500.
• A mental accounts problem?
• The decision opaque frame makes
• for a brainer instead of no-brainer.

23
The Winners Curse

• The winners curse is a concept first discussed
  by three engineers, Capen, Clapp, and Campell
  (1971).
• Suppose that many oil companies are interested in
  purchasing the drilling rights to a particular
  parcel of land.
• Assume that the rights are worth the same amount
  to all bidders, that is,
• the auction is called a common value auction.

24
The Estimates Difficulty

• Given the difficulty of estimating the amount of
  oil in a given location,
• the estimates of the experts will vary
  substantially, some far too high and some too
  low.
• Suppose that the mean of all estimates is equal
  to the common value of the tract.
• What is likely to happen in the auction?

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The winner is cursed

• The winner is said to be cursed if
• 1. the winning bid exceeds the value of the
  tract, so the firm loses money
• 2. the value of the tract is less than the
  experts estimate so the winning firm is
  disappointed
• The winners curse cannot occur if all the
  bidders are rational,
• but rational bidding requires distinguishing
  between the expected value of the object for
  sale, conditional only on the prior information
  available, and the expected value conditional on
  winning the auction.

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An Acquisition Example

• Assume that you represent Company A (the
  acquirer) which is currently acquiring Company T
  (the target) by means of a tender offer.
• You plan to tender in cash for 100 of Company
  Ts shares but are unsure how high a price to
  offer.

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Acquisition Value Evaluation

• The main complication is this
• the value of the company depends directly on
  the outcome of a major oil exploration project it
  is currently undertaking.
• In the worst case
• (if the exploration fails completely),
• the company under current management will be
  worth nothing, 0/share.
• In the best case (a complete success),
• the value could be as high as 100/share.

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Superior Acquisition Synergy

• Given the range of exploration outcomes,
• all share values between 0 and 100 per
  share
• are considered equally likely.
• By all estimates,
• whatever the value under current management
  (target),
• the company will be worth 50 more
• under the management of Company A (acquirer)
• than under Company T (target).

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Information Asymmetry

• You have to determine the offer price for Company
  Ts shares and the offer must be made now,
• before the outcome of the drilling project is
  known.
• You will not know the results of the exploration
  project when submitting your offer,
• but Company T will know the results when
  deciding whether to accept your offer.
• Company T is expected to only accept
• any offer that is greater than or equal to
  the value of the company (per share) under its
  own management.

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The Offer Price

• As the representative of Company A, you
  deliberate over price offers in the range
  0/share to 150/share.
• What offer per share would you tender?
• A typical thinking is as follows
• The firm has an expected value of 50 to
  Company T, which makes it worth 75 to Company A.
  
• If a bid is somewhere between 50 and 75,
  Company A should make some profits.

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The Winner Will Lose

• A correct analysis must consider the asymmetric
  information that is built into the problem and
  calculate the expected value of the firm
  conditioned on the bid being accepted.

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The Winner Will Lose

• Take bidding 60 for example
• If the bid is accepted, the the company must
  worth no more than 60 under the current
  management.
• Since all of the values less than 60 are equally
  likely, this implies that the firm, on average,
  will be worth 30 to the current owners, or 45
  to you.
• By bidding 60, you expect to lose 15.
• In fact,
• for any bid X,
• you expect to lose 0.25X.

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Act On It! But How?

• If you have figured out the winners curse and
  you realize that your competitors are making
  mistakes,
• how can you exploit your comparative
  advantage over other oil firms?
• If you react by optimally reducing your bids,
  then you will avoid paying too much for leases,
• but you will also win very few auctions.

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Your Choices To do or not to do

• You could let your competitors win all the
  auctions and try to make money by selling short
  their shares.
• You can share your new knowledge with your
  competitors, urging them to reduce their bids as
  well.
• Are you better off if your competitors are also
  rational?
• You may decide not to bid at all!
• What is your risk if you decide not to bid at
  all?