Back in 16th century, Dutch East India Company (Verenigde Oostindische Compagnie or VOC) was the first company to issue shares and bonds through Amsterdam Stock Exchange. Then the Wall Street, New York Stock Exchange and reputable large brokerages around the globe emerged.
The expanding arena of different markets during those times encountered series of bubbles which includes starting from the South Sea Bubble, Tulips Mania and The Great Depression. Most investors who were caught up in these prophetic and untimely events often forget to ask most important question, 'How much?', before pouring their hard-earned money.
Benjamin Graham's margin of safety concept withstood the test of time as it also applies to various areas of investments focused to long term investors but it also teaches the discipline needed to be a successful enterprising investor or in the short term.
Warren Buffet defines it as this;
You have to have the knowledge to enable you to make a very general estimate about the value of the underlying business. But you do not cut it close. That is what Ben Graham meant by having a margin of safety. You don’t try to buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And that same principle works in investing.
In simple terms, margin of safety principle tells that we should buy businesses which are undervalued or lower than the current market price. It serves as a buffer that if some variables were missed during your assessment, it will not result to the permanent impairment of capital. But the real question is, how do you know if a business is lower than its current market valuation?
Before you can put a price to a certain stock or any other kind of investment, first, you should value the business. Most of the time, an investor will base his judgement speculatively on news from the crowd.
Their is a way for me to assess a certain company if it is worth investing my money.
Legal Disclaimer: I am not a financial adviser and all strategies are purely based on my opinion and experience as I invested in a Asian market and thus, it should not be taken as an investment advise.
I usually look into companies by answering the five Ws and one H:
- What are their goods and services?
Are their products will still be there after 50 years? Is it innovative? Does it have a monopolistic quality? Are their only few competitors?
- Who are the management team?
The management sets the tone and the direction of the company. They have the stewardship function. Therefore, we have to do a background check on them if they are not involved in some illegal activities, convicted, interlocking manager issues and other things that has something to do with trust and integrity. If you are confident enough with them, then you would be confident that the organization is on it's right track.
- When?
This question usually refers to the timeline of their goals. Is it realistic? We will build another innovative kind of aircraft under three months. We will bring the fastest computing system in the company in a months time. Then you should ask yourself first if these can be really achieved with those span of time.
- Where?
Most of the time, companies look for areas where they can cut costs to maximize shareholders' wealth and at the same time fulfilling their roles in the community where they operate. This is where the 'Research and Development Expense' come in, companies who allocate funds for their R&D usually have lower costs especially on their processes, customer returns, manufacturing inefficiencies.
- Why?
This answers a question about their vision. After considering the previous questions, look if they have a clear cut vision. Do they want to be the number 1 ice cream in the world? Do they want to be the best blockchain platform focused in transfer payments? A specific vision has higher probabilities of being achieved.
- How?
This is the last and the most critical. After setting their specific vision, now what? Do they have specific goals to achieve it? Most of the blockchain projects or company goals were too broad, which means they have a lot announced ongoing projects but almost none of them were being accomplished. This is a sign of losing sight of the big picture. Some successful companies sets a specific goal then finishes it before going to another project or some of them simultaneously do it with other projects but the number is still few. The next time you evaluate how great is the company or platform, always look into their projects. It's a red flag if their's a lot and constantly stagnant or having no progresses at all.
All these questions were based on Benjamin Grahams four core business principles:
Principle 1: “Know what you are doing — know your business.”
Principle 2: “Don’t let anyone else run your business, unless (1) you can supervise his performance with adequate care and comprehension or (2) you have unusually strong reasons for placing implicit confidence in his integrity and ability.”
Principle 3: “Don’t enter upon an operation — that is , manufacturing or trading an item — unless a reliable calculation shows that it has a fair chance to yield a reasonable profit.
These means that physical expansion do not always result to profit. It should always be based reasonable calculation basing it on previous expansions of the company, competitors' results, and the industry. Over optimism is the greatest mortal sin in investing.
Principle 4: “ Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it — even though others may hesitate or differ.”
Let me know your thoughts by commenting below or your experience valuing a company including your strategies.
Love,
Ali