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Stockmarkets: From 'trading' to 'safety'... - Views on News from Equitymaster
 
 
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  • May 30, 2006

    Stockmarkets: From 'trading' to 'safety'...

    ...it is all in the 'margin'. One of the reasons for the latest decline in Indian equities, apart from the 'FII selling', was margin covering, whereby stock buyers sold on every opportunity to minimise their losses so as to repay the money that they had borrowed from their brokers on margin. After the crash, now emerges another 'margin' related concept, whereby participants have been talking of practicing caution and investing in stocks that are high on the 'margin of safety' principle. One thing is, however, sure. Stock buyers seem to be realising the need to understand the 'risk' part of the equation and not just concentrating on 'returns'.

    In such times when 'risk' rears its head above 'returns', it becomes imperative for buyers in equities to give heed to one of the breakthrough concepts of investing given by the 'father of intelligent investing,' Benjamin Graham - margin of safety.

    Margin of safety means 'always building a 15,000 pound bridge if you are going to be driving 10,000 pound trucks across it'. - Benjamin Graham.

    For stocks, the margin of safety lies in an expected 'earning power' considerably above the interest rates on debt instruments. Simply calculated, earning power is equal to the reciprocal of P/E ratio, i.e., E/P. For example, a stock with a P/E ratio of 8 has an earning power of 1/8, or around 12%. In common parlance, this is often known as the 'earnings yield.'

    Considering this example, assuming that the stock has an earning power of 12% and that interest rates on a 10-year bond is 7%, then the stock buyer earns an excess of 5% over bond, which is a margin in his favour. While such bargains are hard to find in these times, the level of margin a stock buyer considers safe is dependent on his ability to take risks.

    On a broader basis, if one were to the look at the adjacent chart, it becomes clear that the margin of safety of the Indian equities (in a broader sense) has been on a decline over the past few months (since May 2005, to be precise). This is while the benchmark index (BSE-Sensex) has been on a consistent rise, though with the exception of the recent 'healthy correction.' The decline in margin of safety of the Sensex can be traced to two major factors:

    1. Steady rise in the 10-year bond yield (from 5.3% in May 2005 to 7.1% in May 2006).

    2. Decline in earnings yield (E/P), mainly due to slowing down of India Inc. earnings growth. This has been indicated by a faster rise in P/E of the Sensex than the Sensex value itself.

    The second part of the risk with respect to Indian equities arises from the reducing gap between Indian and US yields on the respective benchmark 10-year papers. This carries with itself the 'risk' of the Foreign Institutional Investors (FIIs) money that has chased emerging market equities (including India) in the past few years, flying back to the safer US treasury bills and bonds, which now become relatively more attractive.

    Conclusion
    While the concept of 'margin of safety' has enabled investors in the past to take calculated decisions on their proposed investments, having a stock with a high margin of safety is no guarantee that the stock buyer would not face losses in the future. Businesses are subject to various internal and external risks, which may affect the earnings growth prospects of a company over the long-term. But if you have a portfolio of stocks selected with adequate margins of safety, you minimise your chances of losses over the long term. In this context, stock selection is of great importance.

     

     

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