On the 'Margin of Safety' I Consider in Investing for Stock Market Beginners
PER of 5x.
PBR of 0.5x.
Dividend yield of 5%.
When I find a stock like this,
I think,
‘This is incredibly cheap.’
Naturally, my eyes are drawn to these kinds of numbers when I look at stocks too.
However, as I have continued to invest,
I have come to think that ‘cheap stocks’ and ‘safe stocks’ are completely different.
This is where the concept of
‘Margin of Safety’
becomes important.
This is a concept that I personally value quite highly when investing in stocks.
In this article, I will start with
‘What exactly is a margin of safety?’
and then discuss
how I think about it in the context of cyclical stocks, which I like.
Furthermore,
I would like to write about my own thoughts on the relationship between the margin of safety and catalysts, as well as ‘value traps’ that may look cheap at first glance.
First of all, what is a ‘margin of safety’?
The concept of a margin of safety is famous as a principle emphasized by Benjamin Graham in investing.
It may sound difficult, but
I think of it quite simply.
It is
‘buying at a price sufficiently lower than the corporate value you estimate, creating a buffer so that even if your prediction is wrong, you won’t suffer a fatal blow.’
For example,
suppose you research a company and
conclude that ‘this company is worth about 1,500 yen per share.’
If it is being sold on the market for
1,000 yen,
then,
1,500 yen – 1,000 yen = 500 yen.
You can buy it for about 33% less than the corporate value of 1,500 yen.
This 500 yen.
This margin of about 33%
becomes one ‘margin of safety.’
I will also write about the relationship between the margin of safety and catalysts, as well as ‘value traps’ that may look cheap at first glance.
I will also write about the relationship between the margin of safety and catalysts, as well as ‘value traps’ that may look cheap at first glance.
Why is it necessary to go out of your way to buy cheap?
The reason is simple.
Because my own predictions are usually wrong.
I analyze companies,
read financial statements,
research industries,
and forecast future profits.
Even so, it is impossible to predict the future with 100% accuracy.
I might get the profit forecast wrong.
The economy might take a downturn.
Raw material prices might rise.
Exchange rates might move in the opposite direction of what I expected.
Competitors might become stronger.
Unexpected capital investment might become necessary.
A scandal might suddenly occur.
In other words,
even if I think it is worth 1,500 yen,
it might actually only be worth 1,300 yen.
Things like that happen all the time.
That is why,
Do not buy a company you think is worth 1,500 yen
for 1,500 yen.
If possible,
1,200 yen.
1,000 yen.
800 yen.
Buy it at a price where,
even if your calculations are slightly off, you can still withstand it.
I believe this is,
the most important part of the margin of safety.
‘The stock price is cheap’ and ‘it is cheap relative to corporate value’ are completely different things.
I think this point is especially important.
For example,
a company with a stock price of 100 yen.
Looking only at the stock price,
it somehow feels cheap.
But if that company’s value is only 50 yen per share,
even 100 yen is expensive.
Conversely,
even for a company with a stock price of 10,000 yen,
If a share is worth 20,000 yen,
that means you are buying it at half price.
In other words,
what is important is,
not whether the stock price itself is high or low.
It is whether the current stock price is high or low relative to the company’s value.
That is what matters.
Similarly,
just because the PER is 5x doesn’t mean it’s cheap.
Just because the PBR is 0.5x doesn’t mean it’s cheap.
Just because the dividend yield is 5% doesn’t mean it’s cheap.
That is not necessarily the case.
If you get this wrong,
you might find that “you thought you bought a bargain stock, but the price keeps falling forever.”
This can happen.
Margin of Safety (1): Thinking from the perspective of ‘Asset Value’
There are several ways to think about the margin of safety.
One of them is,
the method of thinking from the perspective of asset value.
For example,
A certain company has
50 billion yen in cash.
20 billion yen in securities.
30 billion yen in valuable real estate.
It holds these assets.
On the other hand,
it has 20 billion yen in interest-bearing debt.
If we think about it in a very simplified way,
50 billion yen
+ 20 billion yen
+ 30 billion yen
– 20 billion yen
= 80 billion yen.
A company with that much asset value is,
in the stock market,
valued at a market capitalization of 40 billion yen.
If that is the case,
one could think,
‘Isn’t this quite cheap?’
and consider it.
If you bought the whole company for a market cap of 40 billion yen,
it is a situation where you get more assets than that along with it.
In places like this,
A margin of safety is created from an asset perspective.
However, ‘PBR 0.5x’ does not mean ‘half-price sale’.
There is a pitfall here as well.
For example,
a factory.
Even if it has a book value of 10 billion yen,
it might only sell for 3 billion yen if you actually try to sell it.
Inventory is the same.
Even if it is listed as 10 billion yen on the books,
it is meaningless if it is unsellable inventory.
Furthermore,
goodwill,
retirement benefits,
lawsuits,
future equipment upgrades,
environmental compliance costs,
and so on,
there are things that cannot be seen through simple BPS alone.
Therefore,
‘Because the PBR is 0.5x, I can buy the company at half price!’
That is not the case.
You need to look at the contents of the assets as well.
Margin of Safety (2): Thinking from the perspective of ‘Earning Power’
The other one is,
a method of thinking based on the company’s earning power.
For example,
under normal conditions,
there is a company that can earn about 200 yen in earnings per share (EPS).
If it is that company,
suppose I consider a P/E ratio of about 10 times to be reasonable.
200 yen × 10 times = 2,000 yen.
In other words,
I consider the corporate value to be around 2,000 yen.
If that,
is being sold in the market for 1,200 yen,
then,
even looking at it from the perspective of earning power,
there might be a certain margin of safety.
However,
this is where the most important problem arises.
That is,
‘Is that 200 yen EPS really a normal profit?’
what it means.
In cyclical stocks, ‘low P/E ratio equals undervalued’ is dangerous
This is something I am particularly conscious of when I invest.
Steel.
Non-ferrous metals.
Shipping.
Chemicals.
Semiconductors.
Shipbuilding.
These types of industries,
have profits that fluctuate significantly depending on the economy and supply and demand.
They are what are known as,
cyclical stocks (economic cyclical stocks).
is what they are.
For example,
a company is doing exceptionally well,
with an EPS of 300 yen.
And a stock price of 1,500 yen.
Let’s assume that.
The PER is,
1,500 ÷ 300 = 5 times.
A PER of 5 times.
Looking only at the numbers,
it looks extremely cheap.
“A PER of 5! This is undervalued!”
is what one tends to think.
However,
the problem starts here.
What if that EPS of 300 yen
was a profit made at the peak of market conditions?
The following year,
market conditions worsen,
and the EPS,
300 yen
↓
80 yen
falls to that level.
Then,
even if the stock price remains at 1,500 yen,
the PER is,
1,500 ÷ 80
= approximately 18.8 times.
A company that had a P/E ratio of 5 until just a moment ago
suddenly becomes a P/E ratio of about 19.
Cyclical stocks can sometimes look cheapest when they are making the most profit.
I think this is both the interesting part of cyclical investing,
and also the scary part.
Profits are at an all-time high.
P/E ratio is 5.
Dividend increase.
The news says they are doing great.
Even looking at the financial statements, the numbers are incredibly good.
At times like this,
they look the most undervalued.
But in reality,
that was the peak of their profits.
This can happen.
Conversely,
when performance deteriorates,
and there is almost no profit.
The P/E ratio is 30x.
Declining profits.
The news is also full of bad material.
At first glance,
it looks extremely overvalued.
However,
it could actually be right before the market hits bottom.
That kind of thing happens.
Therefore,
when looking at cyclical stocks,
looking only at the current P/E ratio doesn’t mean much.
I prefer to look at,
‘how much this company can earn under normal market conditions’
instead.
Personally, I think in terms of three scenarios: ‘bearish, standard, and bullish’.
For example,
regarding a certain cyclical company,
I try to think about the corporate value in my own way.
Bearish scenario
Market deterioration.
Profit decline.
Fair value 900 yen.
Standard scenario
Average market conditions.
Fair value 1,500 yen.
Bullish scenario
Market rise.
Profit growth.
Fair value 2,500 yen.
is assumed.
If the current stock price is 800 yen,
I think it is quite interesting.
Because,
it doesn’t have to be a bullish scenario.
In a standard scenario,
800 yen → 1,500 yen.
Even if it becomes a bearish scenario,
the assumed value is 900 yen.
Of course, stock prices do not move exactly according to corporate value, but
at least as a way of thinking,
It can withstand even a bearish outlook.
This is
the form I like.
Stocks that won’t make a profit unless a bullish scenario plays out are scary.
Conversely,
if the same company
had a current stock price of 2,000 yen, what then?
Bearish: 900 yen.
Standard: 1,500 yen.
Bullish: 2,500 yen.
Current stock price: 2,000 yen.
In this case,
unless a bullish scenario occurs,
you won’t make much profit.
Market conditions improve.
Company profits increase.
The market values it highly.
Several conditions
all need to go well.
I,
Rather than this kind of investment,
I want to buy at a point where it’s okay even if my prediction is slightly off.
The margin of safety and a ‘catalyst’ are different things
Here is one more thing,
that I think is important.
That is,
a catalyst.
A catalyst is,
simply put,
a ‘trigger’ for a stock price to be re-evaluated.
I,
think of the margin of safety and a catalyst separately.
The margin of safety is,
what protects the downside.
A catalyst is,
what resolves the undervaluation.
For example,
a PBR of 0.5x.
Abundant net cash.
The core business is also profitable.
It is cheap no matter how you look at it.
However,
What if it stays at a PBR of 0.5x for 10 years?
It is cheap, but,
it stays cheap forever.
That can also happen.
So-called,
perpetually undervalued stocks.
Margin of safety + catalyst
For example, there,
share buybacks.
dividend increases.
sale of cross-shareholdings.
real estate sales.
dissolution of parent-subsidiary listings.
takeover bids (TOB).
price hikes.
large orders.
market recovery.
changes like these occur.
Then,
it becomes a catalyst for the market to re-evaluate the company.
That is why I,
simply put,
prefer
companies that have
a margin of safety and also a catalyst
over just ‘cheap companies’.
What I like are ‘companies with multiple layers of margin of safety’.
Furthermore,
I believe it is better to have
multiple margins of safety rather than just one.
For example,
a PBR of 0.6x.
Net cash.
Profitable core business.
Dividend yield of 4%.
Capacity for share buybacks.
Valuable real estate holdings.
Significant cross-shareholdings.
Market conditions are at the bottom.
Furthermore,
there is even the possibility of a TOB by the parent company.
If it were a company like this,
even if one prediction were to be wrong,
there is a possibility that other factors would support it.
Even if the market recovery prediction is wrong,
there is asset value.
Even if the profit forecast is wrong,
the financial position is strong.
Even if the stock price is not evaluated immediately,
there are dividends.
Furthermore,
there are also catalysts like share buybacks or TOBs.
I consider this kind of state to be
a state with multiple safety nets
as I think about it.
The most frightening ‘value trap’
Conversely,
what I want to be most careful about is
Companies that appear to have a margin of safety,
but actually do not.
What is known as,
a value trap.
For example,
a P/E ratio of 4x.
A P/B ratio of 0.4x.
A dividend yield of 6%.
Looking only at the numbers,
it looks incredibly attractive.
However,
sales are declining every year.
Operating cash flow is in the red.
Debt is increasing.
The dividend payout ratio exceeds 100%.
Equipment is aging.
There is a possibility of a capital increase.
The industry itself is shrinking.
What if it were a company like this?
Certainly,
It looks cheap when you look at the ‘current numbers’.
However,
there is a possibility that the corporate value itself is declining every year.
Whether the ‘stock price dropped’ or the ‘corporate value dropped’
I think this difference
is extremely important.
The stock price
went from 1,000 yen to 500 yen.
‘It’s half price!’
I think.
But,
if during that time the corporate value also
dropped from 1,000 yen to 400 yen,
then 500 yen is not cheap.
Conversely,
if the corporate value remains at 1,000 yen,
but due to market sentiment or similar factors,
only the stock price dropped to 500 yen,
then
it becomes quite interesting.
That is why I,
when stock prices fall,
do not simply,
think, ‘It’s become cheaper!’
I look at,
has the stock price fallen even though the corporate value is maintained?
This is,
I believe,
one point that distinguishes value traps from,
truly undervalued stocks.
Things I consider when looking at the margin of safety
In my case,
when looking at a stock,
I generally think about these things.
1. What is the normalized profit, rather than the current profit?
2. If a recession occurs, how far will the profit fall?
3. Can the finances withstand it even if it becomes a deficit?
4. How much net cash is there?
5. Are there hidden assets such as held stocks or real estate?
6. How much debt is there?
7. Is there a risk of capital increase?
8. What is the corporate value in a bearish scenario?
9. What is it in a standard scenario?
10. Is there a sufficient margin between the current stock price and that value?
11. Is there a catalyst for the undervaluation to be corrected?
Of course,
I cannot calculate all of this accurately.
Corporate value is something that,
looks completely different depending on who is looking at it.
I don’t know future profits either.
I don’t know the market conditions either.
I don’t know interest rates or exchange rates either.
However,
precisely because I don’t know, I take a margin of safety.
I believe this is,
the most important part of the concept of a margin of safety.
Rather than ‘how high will it go,’ it’s ‘how far will it fall if I’m wrong?’
When you are investing in stocks,
you inevitably want to think about the upside.
‘This stock will double.’
It will go up 50% from here.
It will jump at the next earnings report.
If it rides the trend, it could even be a ten-bagger.
Of course,
it is important to think about the upside.
I think about it too.
But,
before that,
there is something I want to consider.
That is,
how far will it fall if I am wrong?
.
What happens if all my predictions are wrong?
What if the market conditions do not recover?
What if profits do not grow as expected?
What if the share buyback I was hoping for does not happen?
What if it is not subject to a TOB?
Even then,
can I hold it at this price?
That is what I think about.
I believe that investing is not a ‘game of predicting the future’.
Predicting the future perfectly is something that
no one can do.
No matter how much you analyze a company,
no matter how much you research an industry,
unexpected things will always happen.
Therefore,
rather than looking for
a ‘stock that will definitely go up’,
I want to look for a ‘stock price where I can survive even if I am wrong’.
If it goes up, the gains are large.
However,
even if I am wrong, it won’t be a fatal blow.
I invest in such places.
I think that is more important
for staying in the stock market for a long time.
Lastly,
when we talk about a margin of safety,
it means
‘buying undervalued stocks’.
It is often thought to be that way.
However,
I think a little differently.
A margin of safety is,
not simply looking for cheap stocks.
My analysis might be wrong.
The future cannot be predicted.
Unexpected things also happen.
Accepting that from the start,
I buy at a price where it is okay even if I am wrong.
The margin for that.
That is,
what I think a margin of safety is.
Instead of only looking at a future where stock prices rise,
I also imagine a future where I am wrong.
Based on that,
I buy at a point where I still think it is sufficiently cheap.
Rather than aiming to predict the future perfectly,
I make sure to survive even if I get the future wrong.
For me,
The ‘margin of safety’ in investing is
buying a buffer that allows you to survive even if your future predictions are wrong
.
And,
if possible,
having a catalyst there as well.
Stocks like that,
I intend to keep searching for in the future.