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Some pointers to curb downside risks
Mon, 21 Oct Pre-Open

To be a successful investor, the aim is simple. Not to overpay for an asset i.e. not overpaying in relation to the intrinsic value of the asset. The intrinsic value of any asset would be the present value of cash flow that is expected in the future. For stocks, the same would be dividends and price appreciation. The two of course depends on many factors including earnings growth, margins, capital allocation, and cash flows, amongst others.

Warren Buffett has a famous saying which talks about it being better to pay a fair price for a good company rather than a good price for a fair company.

The thing is that more often than not, people tend to become biased when they see a 'good' company. And the biasness gets stronger as they hear and discuss about the company with others, especially when others share similar views.

This action would only make one compromise on their principle of being a value investor and end up purchasing stocks at higher levels. This would be possible by playing around with the numbers to arrive to a desired target price or maybe by increasing multiple or lowering discount rates, depending on metric used.

A key question is how to avoid biasness... As per an article in the Financial Express, 'the way out is to eliminate all bias before starting on a valuation, but this is easier said than done; the reason being that most investors are exposed to external information, analyses and opinion about a company.'

But there are ways of reducing bias. The first is to avoid taking strong public positions on the value of a company before the valuation is complete. The second is to minimise, prior to the valuation, the stake investors have in whether the company is under- or over-valued.'

In short one must cut out and ignore all the noise around, as this could easily influence one's views and inputs to arrive at a price.

We also believe a good practice would be to not play around with multiples on regular intervals and only do so when the dynamics of the company or industry change.

Whatever you do build in some margin of safety...

We have always been of the belief that investors should not ignore the concept of margin of safety given that it is one of the most important and timeless investment concepts. In The Intelligent Investor, Ben Graham defines it as "A favorable difference between price on the one hand and indicated or appraised value on the other. That difference is the safety margin. It is available for absorbing the effect of miscalculations or worse than average luck." He also mentions, "The margin of safety is always dependent on the price paid. It will be large at one price, small at some higher price, nonexistent at some still higher price."

Having said this, the concept is broadly aimed at trying to curb the risks of downside. But it does not guarantee that the stock buyer would not face losses in the future. Given the volatile markets that we have experienced in the past few years, and the fact that businesses are subject many risks, which at the end of the day can affect earnings and growth prospects of companies.

For information on how to pick stocks that have the potential to deliver big returns, download our special report now!

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1 Responses to "Some pointers to curb downside risks"

ranbir

Oct 2, 2016

please guide

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Equitymaster requests your view! Post a comment on "Some pointers to curb downside risks". Click here!

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