I read the articles in Sing Chew early this month regarding some recommendations of blue chip companies in Bursa in the links below.

http://biz.sinchew.com.my/node/121845

http://biz.sinchew.com.my/node/122204?tid=8#ixzz3kxwR8MQY

It mentioned that after the steep fall in Bursa in August 2015, many experts in the market expressed their opinions that it is the right time to buy some blue chips in Bursa because it has shown that when the market rebounds, they are the stocks which will lead the recovery of the market. Sing Chew provided some information on the 30 stocks which form the KLCI index as a reference for investors who are interested to look at some blue chips to invest in. This is shown in Table 1 in the Appendix.

Assuming that we trust the analysis of the experts, which stock shall we invest in? This leads us to a very important concept of value investing, Margin of safety, MOS. It is the 3 most important words in value investing.

Margin of Safety (MOS)

I have many former classmates in high schools and in university and we often meet up for dinners before Chinese New Year every year. We are trained civil engineers and we used to emphasize a lot about the safety in design. For example in geotechnical design for foundation piles, we use a factor of safety of 1.5 for skin friction, and 2.0 or even 3.0 for end bearing, depending  on how confident we are about the soil condition and the construction process of those piles. All of us know exactly what we are talking about. Many of them are serious investors now. But when I mentioned about MOS in investment, which is much simpler concept, hardly anyone of them ever heard of this three letter words. This includes a number of my friends who are trained accountants and finance professionals, and also a number of remisiers. Just what is MOS?

“Margin of safety if the difference between the intrinsic value of a stock and its market price.” Benjamin Graham

Seth Klarman, a self-made billionaire, who runs Boston-based Baupost with $28.5 billion under management, wrote a book titled, “Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor”. If you are interested to buy his hard cover book, not many of them around, you can get it from Amazon for USD4000 a copy.  He defines MOS in investment as below.

“A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world.”

Warren Buffett explains MOS as below.

“You have to have the knowledge to enable you to make a very general estimate about the value of the underlying business. But you do not cut it close. That is what Ben Graham meant by having a margin of safety. You don’t try to buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And that same principle works in investing.”     

In both quotes above, there is only one common theme that addresses safety. It is the Price. Not whether the business is experiencing profit growth or not for this quarter of the next quarter, not how shareholder friendly the management is.

Simply put, you practice margin of safety by buying an investment at a lower price than the valuation. MOS is designed to make you money having a low chance of losing money.

Outside of investing, it’s a fundamental core to many applications. Funny why investors don’t use it when doing investing. This is what Charles Munger said:

“In engineering, people have a big margin of safety. But in the financial world, people don’t give a damn about safety. They let it balloon and balloon and balloon. It’s aided by false accounting.”

But how to get MOS? Of course you must know the value, and calculate what the MOS is buying the stock at that price below its intrinsic value. But how to get the value then? Can we get it from the company’s website, or Bursa website? Why not our remisier tell us what the intrinsic value of the stock is? That would be easy to make money, with tooth fairy. Life isn’t perfect, is it?

Valuation is Most Important

Valuation is a process of finding what the company is worth and hence its stock.

Valuation is important, but every valuation method has assumptions. What if those assumptions go wrong? How do you limit the damage? It comes back to the price you pay.

This is what James Montier, another authority in value investing says:

“Valuation is the closest thing to the law of gravity that we have in finance. It is the primary determinant of long-term returns. However, the objective of investment (in general) is not to buy at fair value, but to purchase with a margin of safety. This reflects that any estimate of fair value is just that: an estimate, not a precise figure, so the margin of safety provides a much-needed cushion against errors and misfortunes. When investors violate [this principle] by investing with no margin of safety, they risk the prospect of the permanent impairment of capital.”

So we can some values from some kind of valuation methods, and then we compare with its price, and only buy if there is sufficient MOS as shown in Figure 1 below:

Figure 1: Margin of Safety

So if a stock is trading at RM1.00 in the market, and you calculate the company’s intrinsic value as RM1.50, you have a margin of safety of 50 sen. In other terms, the stock is trading at a 33% discount to the company’s intrinsic value.

If the said stock is of a high quality company, it is advisable to buy it at any price that is 20% or lower than the company’s intrinsic value (any price lower than RM1.20). And if the said stock is of a company that is not a good one, you must not buy it for more than 50% of the intrinsic value (only if the price is lower than 75 sen).

What margin of safety does is that it protects you from poor decisions and downturns in the market.

So if you pay just RM1.00 for a stock that you believe is worth RM1.50, even if your analysis goes wrong and the stock is actually worth less than RM1.50, your investment will still be safe.

This disciplined pursuit of bargains (stocks that are available for 30-40% less than their intrinsic values) makes value investing very much a risk-averse approach. But the greatest challenge for you as an investor is to maintain that required discipline.

Invest in Bursa blue chip companies with MOS

Table 1 in the appendix summarizes the target prices, TP, and PE ratios etc. of the 30 component stocks in Bursa. Assuming the analyst has done a good job in getting the target prices of the stocks. Basing on the concept of MOS, which stocks would you invest in for long term?

“If you were to distil the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.” Benjamin Graham

Are you keen to learn how to value what stock is worth and then invest in stocks with margin of safety? Please contact me for an online investment course for a small fee at

ckc14training@gmail.com

K C Chong

Appendix

Table 1: Component stocks of Bursa