EP44 Margin of Safety
This is volume vesting. I'm your host June Kim in this podcast. You'll learn everything related to volume best. It's far better to buy a wonderful company at a fair price, then affair company at a wonderful price. Helo following esters welcomed another episode of volume vesting, I just started this podcast with a coat from Warren Buffett, and this is very important concept. And also it's going to be related to the topic that veer about to talk about in this episode in the last episode. We talked about economic mood, and that is very important concept. If you are trying to understand Warren Buffett's investment philosophy. So if warm buff wants to make an investment he looks at the following criteria. Number one. He wants to buy a business that is simple enough for him to understand the business model. So this is also known as circle of confidence second he looks at the business with Europe will. Competitive advantage, which is also known as economic more every discuss last time. Third. He wants the business with able and honest management team. Lastly he wants to buy business that is selling at a fair price. So this is also known as margin of safety since we talked about economic mode, which is one of the important components of his investment last fee. I decided to talk about margin of safety in this episode. This is a very important concept for you to understand if you're trying to get a grasp of how Warren Buffett invest his money for the long term. So I'm so excited to talk about this topic. I think there are just couple of things that I wanna talk related to margin of safety, and let's just go over them. But before we do that. I just wanna give your creek. Disclaimer as always that this podcast is for entertainment purposes, only, and it is your responsibility to conceal. Salt with your investment professional for any investment decisions. So we have for their do. What are we get started? As I mentioned in the intro. Our topic today on the show as margin of safety. So why don't we define what it means? So that everyone is on the same page in terms of margin of safety concept, so margin of safety arises when there's a difference between intrinsic value of the company and the market price the larger difference the larger margin of safety. So let me just give you a quick example just to facilitate you're in the standing if you're trying to buy a back, maybe from department store, and you know, that this bag is worth one hundred dollars all the time. And you know, that if you buy this back by paying one hundred dollars, you know, that you can resell his back to the people for exactly the same amount. Let's just assume that for the sake of simplicity. And one day, whatever the reason that department store goes on sale for a lot of their items, including this bag and this bag is on sale, and you can get this count. And you came by now at sixty dollars. So you knew that there's a difference between intrinsic value, which is one hundred dollars and the current market price, which is sixty dollars. So there's forty dollars gap, and you buy this back because you know, for sure after the sale ends, you can even resell this back to other people for one hundred dollars. So that's kind of the concept of margin of safety. You can apply exactly the same logic. When it comes to buying stock because for every stock there's a company behind so if you know how to assess the company's interesting value, and if you follow stock market and the market price of the company if that stock prices significantly below entrance value, then that means you have high margin of safety. So that's the definition of margin of safety. And is sounds very simple. Belinda tell you right up front that this is not easy concept to implement when you're making your investment. So what I like to do for deceptive code is to talk about why it is so hard for an average investor to implement this strategy when it comes to buying stocks in the stock market actually before we do that. Why don't we go through several approaches to calculate and to assess intrinsic value of the company because in order to calculate margin of safety. You have to know two things number one, you have to know the stock price which can be easily obtained by just going online and check the stock price, and you have to know the intrinsic value of the company. So you need to know how calculate intrinsic value. I've already covered this topics in the pass this. It's some not going to go to the details of each approach. But what I like to do is like to just go over each of the protest critically. So that we can refresh our memory. I approach is coal. Discounted cash. Flow analysis and this approach requires a lot of a sumptuous for your calculation, for example, you have to know how much cash flow this company's going to generate. Let's say in the next five years or ten years, and once you forecast this cash flows, you have to discount these cash flow back to present value for that calculation. You need to come up with discount rate appropriate for discounting future. Cash flow back to present value. So there are a lot of assumptions you have to make. But theoretically, this is probably the best method. You can use for intrinsic value calculation. The second approach is called ratio. Which is quite simple. You don't maybe have to any calculation if you want to use just trailing value of their company. So for example, if you want to calculate price to earnings ratio, you can simply use the Kerr market value of the company, and for the denominator, you're using trailing twelve month earnings than you don't actually have to do anything, but you can just go to any stock website and you easily find this metric by the same token, you can get easily priced to boot ratio price to cash flow ratio. And in some cases for the denominator instead of using trailing twelve month metric, you can use one year four looking of forecast, for example, if you want to calculate price to earnings ratio by using one year for looking earnings, you can just do that. And a lot of these numbers available Easley on any stock related websites. So there are pros and cons between discounted cash. Flow analysis and racial based approach that third approach you can use. Is simply comparing the market capitalisation against the boot value on the ballot shit. So this approach is also very simple because you can get this book value number directly from the balance sheet easily you might have to make some judgments in order to come to better value number, but it's very simple the loss. One is little bit tricky because this is equity approach where you're trying to says intrinsic value of the company by predicting how much are their competitors are willing to pay for the business that you're interested in buying because if other competitors are interesting buying or large companies are interested in buying this company. They usually have to pay high premium on top of the stock price. And usually this valuation is therefore higher than using other approach. So these are the four main approaches when it comes to assessing intrinsic value of a company. So these are the technical details. You might have to study by yourself and understand fully water. The pros and cons of each approach. But what I like to do for this episode on today's show. I like to talk about why it is so hard to implement margin of safety concept. Even if you give arrived the right intrinsic value. So let's just go over them and see how you can cope with this kind of difficulties. So first difficulty or hurdle that you're gonna face when it comes to applying margin of safety is the fact that all this intrinsic volley calculations are very prone to what assumptions you're making. So for example, I mentioned that if you calculate intrinsic value based on discounted cash. Flow analysis, the final intrinsic volume number is going to vary quite significantly depending on which assumptions using for example. If you're using let's say ten percent his rate versus twelve percent discount rate. Even though is sounds very similar only two percent efforts. But it's going to make a huge difference in the final number also depending on how you wanna forecast future cash flows of that company, your final number is going to be different. And if you use a terminal volume approach, which is very common for discounted cash flow now. Alice's? You always have to come up with some terminal value and diwan is also very subjective. Second hurdle that I want to mention is that margin of safety concept is very subjective concept. What I mean by that is let's say, you know, interest value of their company, then how much margin. Do you on apply when it comes to buying their company? Do you want to have ten percent margin or twenty percent margin thirty percent margin or even more because less the stock's intrinsic values one hundred dollars as stock price fell below? Let's say eighty dollars. So you have approximately twenty percent margin. Then is it the right time to buy stock or do you want big oh margin. Maybe forty percent of fifty percent, and you just wait until you secure their margin. So this is kind of the question that you have to ask yourself when you're buying accompany from the stock market because the company stock price may not go below the threshold. They use said, and you may not be able to buy the company at all in the future. So there's a risk of missing out on buying their company versus there's a risk of stock. Price falling below whatever price you're paying. So you have to determine what is right margin for your investment. Third reason why it is hard to implement margin of safety concept is because in require scenic Amada patient from you because you have to wait until the stock price falls below whatever margin you said, and sometimes it doesn't happen for five years. Maybe six years or may never happen at all. So it requires cigarette. Compati- so that's why I'm saying it is not easy to implement. So we just talked about three reasons why it is not easy to implement this margin of safety concept in a daily vestments situation. So let's quickly go over them. I interest volley calculation is going to vary depending on which assumptions, you're using. For your volley calculation second this margin of safety concept is very subjective. And people may have different threshold for whatever margin date. They won ten percent twenty percent. And so on. Third a requires significant amount of patient because you have to wait until the stock price falls below your threshold. Now what I want to do is. What can we do given all these difficulties when it comes to implementing margin of safety? The first thing that we can do is when you can't quite interesting value instead of just driving dangerous value number to a single number. What warm buffer recommends for the most part is just come up with a range. So let's say you are interesting value ranges, ten dollars to twenty dollars for certain stop. And if the car market volume falls between this range, then maybe you don't want to buy the stuff because you are not securing big enough margin for your safety. But if the stock price falls below ten dollars, which is your minimum intrinsic val- calculation. Maybe you can secure enough margin for your safety, and you can buy stock at that point the second thing, you can do is just pass on whatever stock that you have that skated if. You're not sure about that investment. So if you're not sure about what this business is doing, and what the business model is then you can just pass on their investment. If you're not sure how to calculate intrinsic value of the company you can pass on their investment. If you're not sure that this companies selling below entrance value, then you can pass on that investment. If you're not sure that you don't have enough margin of safety. You can pass on that investment. You can just wait and wait and wait until you finally get to the point where all these criteria. Had check box checked. The third thing that we can do is create a watchlist because that's what I do for my investment per folio. What I do is. I put all these stocks that I'm interested in in my performance watchlist. And what I do is just I just don't do anything until something really bad happened to these companies. And usually there's a scandal that's going to track down to stop price of certain company. And I looked at the situation and try to SAS if a really warrants that stock price Trump that happens all the time even for really great companies. So if that type of scandal happens what I do is I make the SAS men, and if the current assessment shows that stock price drop is now warranted on the that circumstance than I by the company when I believe that the cursed out price is below intrinsic value significantly. Four thing that you can do a don't check stock price all the time. Because if you are checking stock price all the time in every day, then you're going to be influenced by Mr. market, which is done at the concert discussed in the previous episode. So don't check the stock price all the time every day because you're going to be fluent idea in a negative manner. So you can do in order to improve your patience, and temperament is just you make yourself occupy with something else. Maybe do more research on other stocks or do other activities because that's going to be a lot healthier for your mental health. And also it's going to be good for your portfolio management because then you going to allow yourself to develop the patients that is required to be successful investor. Because as I mentioned if you want to implement the margin of safety concept, successfully you need a lot of patients, and you cannot be really patient if you're watching stock market every single day, and you get his tractive by all this media news articles. So I think those are the things that we can do in order to implement margin of safety. But it's always easier said than down and a lot of people know in their head that what they have to do. But when they lose money significant amount of money or even gaining some profits. They just act irrationally, and that's not really healthy for their performance returns. So let's just keep that in mind. I personally think that knowledge is very important. But what's equally important is the temperament and discipline? Even if you don't have the right temperament for the stock market there so way, you can develop your mental muscle. And that's what I liked to do through this kinda podcasting because as you listen to the same thing over and over again, you probably will be able to develop the muscles that. Are required. And that are necessary for it to become a successful in the stock market. And I'm telling you all the time that you need to do the longer investing. You have to develop patients, and that's what Warren buffet in. All the other legendary volume Besters have been telling all the people, but what's quite interesting and funny is that people don't listen to these legendary volume Besters, I don't know why. But that's what happened to a lot of people, and that's just a nature of human being. So if you develop this kind of temperament and muscles mental muscles in order to prevent yourself from doing stupid things when market crashes or market goes up significantly, then you going to be way ahead of other people because other people get super fearful and either sell their stocks when you know stock post. Down. I mean, I'm not saying that you should ask sell the stocks at all. But you have to make the Cessna n- in an objective manner. Not based on your emotions. So that's going to be a huge advantage for you and give you upper hand in many situations. So let's just take a look at watt warm of at has done so far because if you look at fifties or sixties warm buff Ed purchased companies when they're selling at very very low price at one point Warren buffet was able to Cuba a twenty percent of his per folio by purchasing stocks of Dempster meal. So this is the company that has been in decline for quite some time, but warmth of purchase this company. Probably twenty five percent of the value of the company. So this is quite excellent. The price warm of paid. However, this company was obvious to the peer rate over time. But warm, but was able to recoup whatever investment that he made. And also he got an decent return from this company. But this is kind of the Sikh up approach that here da- pted at the beginning of his investment courier but later on Warren Buffett switch his approach. And now as I mentioned at the beginning of this podcast episode. He saying that it's far better to buy a wonderful company at a fair price than affair company at a wonderful price. So he's arguing now that you have to pay maybe a little bit more for wonderful company and over time I'm saying like maybe more than ten years. It's going to bring you a lot more returns. And Charlie Munger once said that you just have to be smart one. If you implemented approach, but if you trying to implement seek our bud approach, then you have to be smart all the time. Because once you buy the company, very, very cheap price. Then you sell the company, and you get the return, but you have to find another company like that over and over again in order to increase your perform value. However, if you buy wonderful compainies, then you don't have to do anything, you just let it run by self, and it's going to generate tons of money for your portfolio. So that's what I wanted to mention related to Warren Buffett. Okay. So I think we talked about a lot of things with respect to margin of safety. I hope that this episode was helpful for you. As I mentioned at the beginning of this episode. I was able to complete the development of the website for this podcast. So we have platform you listen to this podcast. You can just pay a visit to their website. And let me know if you have any comments related to to website that we have for this podcast. Thank you for listening and cenex time.