Investment Concepts

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Investment Concepts: ‘Margin of Safety’ Investing …Simple and Powerful

By Dr. Steve Sjuggerud, President, Investment U
Tuesday, May 27, 2003: Issue #242

Investment concepts can be simple.

Richard Russell reminded me of this in his latest newsletter, with a little story a story that teaches us about the value of avoiding investments that contain more risk than potential return.

Back in 1974, Russell notes, Texaco and Exxon were paying out 10% a year in dividends. Based on that alone, Russell figured that he’d be up 30% in three years time on the dividends no matter what happened.

It was a bear market back then, a scary time to invest. The market lost half its value during 1973-1974. In 1974 Russell figured that even if the stock prices of Texaco and Exxon fell by 30% over the next three years, he’d still have broken even on his investment, because of the dividends.

After sizing up the risks and the rewards, Russell determined, “The margin of safety was so attractive that I bought both stocks.”

In this example, the “margin of safety” principle is where you believe you’ve got ample dividend yields to cover your risk in the stock.

According to Russell, “Today it’s very difficult to find stocks or bonds that fit into this [category]“

But Richard Russell does name a large handful of utility stocks where the big dividends over the next three years should provide you plenty of safety to cover your risk of loss. Readers of my newsletter know that I think a few real estate stocks (REITs) also fit this “margin of safety” investment concept, as they are paying dividends of 7% or better.

Investment Concepts: Buying At A Mega Discount

The term “margin of safety” was an investment concept made famous by Benjamin Graham, the father of “value investing.” Benjamin Graham and Dodd’s “Security Analysis,” written in 1934, is still the bible for budding analysts.

Instead of having income cover your risk of loss, Benjamin Graham prefers to buy stocks ridiculously cheap-consider that his “margin of safety.” Graham knows that his “margin of safety” investment concept is not without risk. In his book “The Intelligent Investor,” he reminds us: “Even with a margin [of safety] in the investor’s favor, an individual security may work out badly.” You’ve still got to spread your bets.

Dan Ferris, a good friend who also likes to buy super cheap, recently recounted the story of Mason Hawkins, one of the longest-running success stories in the investment world, who, like Benjamin Graham, likes to buy ridiculously cheap. Hawkins’ track record is compelling. Over the past two decades, Hawkins has made investors an astounding 44 times their money.

Dan says that Hawkins’ investment concepts are simple in principle and technique: Hawkins tries to determine what he considers the “real” value for a stock, and then he refuses to buy unless it trades for at least 40% less than that value.

By doing this, Hawkins ultimately believes that two-thirds of his returns come from closing of the gap between the price and the “real” value, and only one-third of his returns come from the business growing.

In whatever context, the concept of margin of safety is good to keep in mind. As you consider your next investment concepts, ask yourself these two questions:

Will the income from this investment over the next three years cover my risk of loss in that period? If not
Am I buying at a minimum 40% discount to what I really believe is the value of this business?

Investing can get complicatedinvesting concepts don’t have to be. Asking these two questions before you invest is a great reality check. They may save you from taking on an investment with more risk than potential return.

Good investing,

Steve

Today’s Investment U Cribsheet

Richard Russell’s Dow Theory Letters (www.dowtheoryletters.com) and Dan Ferris’ Extreme Value (www.pirateinvestor.com) are both excellent letters. Russell talks more about the overall market, while Dan gives specific Extreme Value investment advice. Check out the websites.
Benjamin Graham founded the concept of margin of safety. His book “The Intelligent Investor” is the classic bestseller on value investing. Unfortunately (and it is just a sin for me to say this, but it is the truth), it’s a boring read. And it’s a bit technical for most folks. “Stocks for the Long Run” by Jeremy Siegel is both easier to read and it covers much more. It doesn’t cover the exact same ground, but it’s a better use of your time, as long as you can ignore the obvious bias toward stocks.