Friday, April 2, 2010

Risk and Margin of Safety in Value Investing

Risk is an important investing concept that is crucial to value investors. Most investors analyse an opportunity by determining how much they can make on a particular investment (generally of the speculative nature). Value investors have another consideration: how much can they lose on each investment?

Risk is defined in financial theory as the volatility of share prices in relation to their historical average. A share that fluctuates 50% in a certain time period is considered a “riskier” investment. Value investors disagree with this interpretation. Share price movements often have little to no relation to underlying value, especially over the short-term. Value investors believe that risk really is the probability of permanent loss of capital.

Consider the following example: assume Sasol trades at R300 per share. If the price subsequently declines to R200, for a 33% drop, financial theory will dictate that Sasol is now a riskier investment at R200 than it is at R300. Compare this to the movement in the price of Awethu Breweries: if the share price moves from 4 cents to 5 cents, for a 25% gain, Awethu becomes a less risky investment than Sasol. Such a conclusion is not only structurally flawed – it is downright absurd.

Value investors therefore pay as much emphasis on what can be lost as to what can be gained. It is using this logic that the concept of Margin of Safety was first ventured by Benjamin Graham in his investing classic, The Intelligent Investor. A margin of safety demands that the thoughtful investor seek a significant margin between purchase price and intrinsic value in order to protect against incorrect analysis. Value investors have as a primary goal the preservation of their capital. It follows that value investors seek a margin of safety, allowing room for imprecision, bad luck, or analytical error in order to avoid sizeable losses over time¹.

Such a strategy allows value investors to outperform during periods of market decline, whilst lagging during periods of exuberance. When the market increases beyond a level supported by prudent research and fundamentals, value investors find safety in cash. Through patience, diligence and thorough research, the Margin of Safety approach has provided sustainable long-term returns for almost all value investors.