The central concern of all investors in their investment policy is to always ensure a "margin of safety" in their transactions in financial instruments. These financial instruments would include various asset classes, whether equity, debt and/or real estate amongst others. The selection of the asset class for investment would depend on the individual investors personal preferences.
To follow a policy of buying low and selling high, in itself ensures a fair margin of safety for the investor. And in certain respects makes it unnecessary for the investor to accurately estimate the future. For instance, stock prices are associated with the enterprise's earning power. Thus, the margin of safety lies in the earnings over expenses, which in most cases would be a positive figure. There have been occasions in the equity markets, when stock prices have dropped to levels which offer the investor a margin of safety equal to or larger than offered by a debt instrument.
Investors who are well read in the ways of the equity market take full advantage of such opportunities. Opportunities offering a reasonable margin of safety occur during bear market conditions. However, holding stocks during prolonged bear markets is an exercise in frustration for the investor, as stock prices are seemingly going nowhere. There are other market situations like a deep correction during an ongoing bull run or the occurrence of a selling climax, which offer a fair margin of safety to the investors. These opportunities are used by investors to indulge in stock picking to the extent of their available financial resources.
The investor may apply the rules of technical analysis in addition to fundamental tools, to substantiate the buy and sell decisions. And on occasion play the momentum game as timing would be of the essence.
In these situations when stock prices drop to unreasonably low levels, we find that all is well with the underlying enterprise. However, environmental circumstances and/or adverse market action give the investor opportunities to purchase stocks with a fair margin of safety on more than one occasion during the pendency of their investment time horizon.
Let's look at a few numbers to analyze and understand this concept of the margin of safety. Let us say that the fair value of a stock of ABC Ltd is ₹100.00 given its present level of earnings and a fair discounting of this earning. Now, we can safely say that at a price level below ₹100.00, this stock would be undervalued or under-priced, thereby giving the investor an opportunity to buy this stock with a certain margin of safety.
Now, when the price of the same stock moves up to ₹100.00 and beyond, then inflation has occurred in the stock price and the margin of safety is no longer available to the investor. Thus, a reasonable investor would be a seller when the stock price is at ₹100.00 or above. That is at prices over and above its fair value.
In addition to the above, the investor would have to keep in perspective future earnings and future earnings growth estimates. As these add the dimension of the premium which investors are willing to pay over and above the fair value of the stock to be a part of this estimated expected growth rate. All is well if these expectations are met by quarterly results, but if there is a short fall then the stock is punished for this lack of performance.
Putting it short and straight, we have a margin of safety when there is fear in the market and everyone is running for the exit door. It is here, that the investor is able to get high quality stocks at undervalued prices. On the other hand, when greed predominates (when everyone is buying), we can reasonably say that there is no margin of safety available to the investor. As stock prices are at unreasonably high levels and are disconnected from a reasonable estimate of their earnings and future expected earnings. Further, even the penny stocks are showing signs of becoming multi-baggers.
Investors must always pay heed to this concept of the "margin of safety", for their financial wellbeing in the long run.