This is exactly when margin of safety comes handy

Mar 12, 2011

In this issue:
» Oil prices may continue to remain weak
» Why companies with dubious managements must be avoided
» Manufacturing heading back from China to US?
» Economic losses due to earthquakes
» and more!

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Why don't you state the beta for the stock?' asked a subscriber. For the uninitiated 'beta' is a measure of the volatility of a stock in comparison to the market. It is supposed to, in some ways; quantify the risk associated with the stock. But frankly you can rely on the beta for risk measurement only if you live in an unreal world. In reality, stocks are subject to change in investor sentiments due to several external factors. These may range from corruption to political upheaval to economic and natural disasters. And there is no statistical measure that encompasses the risks to the stock from all of these.

We instead prefer to stick to the old fashioned way of relying on the 'margin of safety' for the stock. This may sound too naive as compared to the 'beta'-based calculations adopted by several investment advisors. But we believe that the margin of safety is one of the most reliable means of risk evasion. What's more, it works in the best long term interest of investors.

One of the biggest proponents of Graham's concept of margin of safety, Warren Buffett says "If you're driving a truck across a bridge that says it holds 10,000 pounds and you've got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay, but if it's over the Grand Canyon, you may feel you want a little larger margin of safety". He goes on to add "You must leave yourself an enormous margin of safety. You build a bridge that 30,000-pound trucks can go across and then you drive 10,000-pound trucks across it. That is the way I like to go across bridges."

Thus when markets react unreasonably to domestic or external factors, it is the margin of safety that long term investors can fall back on. In many ways it acts as an insurance against the most unforeseen risks. Economic and natural disasters like the latest quake in Japan reinforce this belief.

Do you look for margin of safety while investing in stocks? Let us know your views or post them on our facebook page.

 Chart of the day
Earthquakes and the accompanying natural disasters like the tsunami have caused huge losses to human life and economies over the past decades. As per an estimate from Centre for Disaster Management, since 1900, earthquakes in the Asia Pacific region alone have led to loss of 1.1 m lives and US$ 545 bn (adjusted to 2010 inflation) in economic value. Countries like China, Japan and Indonesia are amongst the most earthquake prone regions in the world. But when it comes to withstanding the impact of such natural disasters few nations have the adequate disaster management infrastructure. As today's chart shows, India ranks fourth amongst the countries hit by earthquakes in the past 3 decades, in the Asia Pacific region.

Data source: Wikipedia

Oil prices are once again in the headlines. Just that this time the focus is not on Middle East. After China's disclosure of highest trade deficit in the last seven years, oil prices have another real reason to remain weak. Post the recent earthquake and tsunami, Japanese refineries have shut down thus hurting the demand for crude oil. However, the earthquake has shut nuclear plants as well. And that could mean utilities burning more oil for energy needs, thus raising its demand and prices.

What soothes concerns is that the OPEC group has already eased oil supplies. But it will be a little early to count on the cartel to maintain that. We w

ould rather wait for its next meeting in June. Meanwhile, oil prices in the short term will be an interesting spectacle to watch with forces like China and Japan on one side and Middle East on the other. For India, easing oil prices could certainly be benign in the near term, given its impact on inflation and trade deficit.

Pharma company Wockhardt is a perfect example of why investors should shun businesses having dubious management at the helm of affairs. In a latest development, the Bombay High Court (HC) on Friday admitted a winding up petition against Wockhardt. The move itself is not surprising considering the mess that the company got itself into.

For starters, it had issued FCCBs to the tune of US$ 110 m way before the global meltdown. This at a time when raising FCCBs in a bull market had become the trend. The money was raised to finance a string of acquisitions that Wockhardt made in Europe. Then at the height of the crisis, when currency volatility was at its peak, the company made some bad bets on derivative instruments. This resulted in huge losses. What exacerbated the situation was that the management refused to acknowledge such investments then. On top of that the debt steadily accumulated on its books. To such an extent that the company was unable to repay the FCCB bondholders at the time of redemption. As a result, it had to go in for debt restructuring. Moreover, the company's relationship with its bondholders has considerably soured. All this has raised a question mark over its future. Indeed, companies having questionable managements and bloated debt are those that investors should avoid investing in at all cost.

White smoke is billowing out of large chimneys, cogs are whirring, and products are moving quickly down the assembly line. American factories have woken up from a long slumber. They are now slowly but surely coming back to life. For the first time in a number of years, the manufacturing sector in the US is doing better than the broader economy. Post the recession, output fell by 15% from end-2007 till mid-2009. Jobs were cut, customers lost credit access, car companies went bankrupt, and the ancillary industries lay dormant. However, output has now climbed up sharply, and is now just 5% below its peak levels. Unemployment has fallen more sharply in Illinois, Ohio and Michigan, versus the national average. These states are key manufacturing hubs.

But, has growth has been broad based? Is the growth coming from an improving domestic economy? Maybe not. Companies like Cisco, Intel, Caterpillar and John Deere are seeing huge growth. These companies make products like computers, machinery, electronic equipment, trucks, construction equipment, etc. Exports have been increasing due to greater demand from emerging markets. A weaker dollar has also helped the situation. Obama's Council of Economic Advisers recently came up with an interesting study. Each additional 1% growth of another country boosts its imports from the US by 3%. Thus, it expects strong growth to come in from Mexico, and other growing economies. America, used to be, and still is, the buyer from the world. Especially from China. We are wondering whether, the tables are going to be turned.

It was a negative week for the world stock markets as all of them closed the week in the red. This was a combined effect of the Middle East crisis as well as the earthquake/tsunami which hit Japan yesterday. Not surprisingly, Japan was amongst the biggest losers of the week down 4.1%. The strongest performing market of the week was China down 0.2%. The Indian stock market indices closed 1.7% lower for the week. Amongst sectoral indices, all indices barring realty and oil & gas closed in the red.

Data source: Kitco, Yahoo Finance

 Weekend investing mantra
"Success in investing doesn't correlate with I.Q. once you're above the level of 125. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing." - Warren Buffett

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2 Responses to "This is exactly when margin of safety comes handy"


Mar 14, 2011

"Why companies with dubious managements must be avoided"
The pharma company having a good core business makes a couple of wrong financial decision which lands it into deep trouble. Isnt it wrong to question the integrity of management in this case ? I mean they are good pharma guys .. bad financial managers.. thats it.


Balakrishnan R

Mar 12, 2011

This is in reference to number of earthquakes a country has faced. Russia and China are much larger countries compared to Japan. So just a number may not show the real threat. May be number of earthquakes a country has faced divided by concerned country's area may give a realistic picture. If done in such a way, may be Japan may over take everybody else. And Russia may be a very very safe place concerned to earthquake.

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