Margin of safety and the long haul

Let's say you're a farmer who usually buys 10 bags of fertiliser a year. At $30 per bag, you're a happy, regular customer. Then, inexplicably, the price falls to $20.

How do you respond? To use sharemarket parlance; you back up the truck. Then you fill it with fertiliser. You were happy to buy at $30 a bag but at $20 you're ecstatic.

This is the way of the world. When the price of something we buy regularly falls, we buy more of it. Except in the sharemarket.

Here, especially among inexperienced investors, that rationale doesn't usually apply. When prices fall, many investors sell.

It's strange don't you think? Why should the sharemarket be so different to every other area of commercial life? To our minds, it isn't. What this little analogy reveals is one of the cornerstones of value investing: the difference between price and value.

Having bought hundreds of bags of fertiliser over the years, a farmer instinctively knows what a bag of particular fertiliser is really worth. If he spends $30 and gets more than that back in the quantity or quality of the crops he's growing, it's a worthwhile investment.

When the price of a particular brand falls to $20, he knows he's getting a bargain. But those who've never wielded a pitchfork wouldn't have a clue.

They don't know a bargain bag of fertiliser from a bunch of grapes because they can't assess how much using the fertiliser will add to the value of the crop at harvest time.

Price is what you pay, value is what you get

It's exactly the same with stocks, something that Benjamin Graham, seen as the founder of value investing, knew instinctively. Graham said that “price is what you pay, value is what you get”. And there's a big difference between the two.

We estimate the value of News Corp is about $25.00 a share over the long term. That means that at $16.00, which is the current price, you're getting the stock at a 36 per cent discount to our assessment of its value.

The problem arises when investors mistake price for value. If you know what a stock is really worth then you're happy to buy more as the price falls, just as you would bags of fertiliser. This approach has become so widespread it has its own phrase, “averaging down”.

We've continually called News Corp a buy, especially as the price plummeted, because we believe we have a good idea of the stock's true value. Only when one has little idea of value does one panic when the price falls. That leads us to “margin of safety”.

Margin of safety

As the price of a stock falls below our estimate of its value, the margin of safety in buying increases.

After recommending News Corp as a Buy at $19.84 on July 24, 2015, the price fell to $15.44 on June 27, 2016. We continue to recommend it as a Buy because the margin of safety – the difference between price and value – has increased.

When a share price rises above our estimate of its value, as we believe it has with say Cochlear, the opposite situation exists. Instead of a margin of safety in buying the stock, there's actually a margin of risk in holding onto it.

Of course, that doesn't mean that the price will fall directly after our recommendation. It may well continue to go up, as it has with Cochlear. But all that means is that the margin of risk in either holding on or buying in is increasing too.

It isn't hypocritical for us to keep calling a stock a buy as the price falls or urging you to sell when the price keeps on rising. Just as a stock can become very expensive, so too can it become very cheap.

Fallible

We're as fallible as any investor in picking short-term share price movements. The fact that we recognise this and devote all our energy to identifying long-term value is what sets us apart.

We are far better judges of what a stock is actually worth than we are judges of what a collection of other people think a stock is worth. And the two are very, very different.

That brings us to the issue of establishing a stock's value, the topic of next week's article in this series on investing approaches. 

Read part one in this series, "The essence of value investing" - click here.