Originally written in Chinese by Qiu Guolu
Translated by Yi Liu
Companies with margin of safety usually have the following characteristics:
1. If the sun is not shining on the east, must be on the west. (Englishg: lose here, gain there). Give someone an inch and he’ll run for a mile.
There is a joke that making tofu is the safest business: make it hard is pressed tofu, make it diluted is tofu pudding, make it thin is tofu sheet, make it disappear is soy milk, leave it stink is stinky tofu.
In the future, there are N scenarios, the company is good as long as 1 scenario can make money. lose here, gain there, this is the margin of security.
Stocks that are too demanding for the future have no margin of safety. And as Murphy’s Laws of Combat says, weapons that must be combined to use are generally not shipped together.
When buying construction machinery stocks last year, I thought about these policy/trend/vision: machine substitutes labour, indemnificatory apartment, urbanization, industrial upgrading, industrial relocation, expansion of production capacity, the grand western development program, import substitution, internationalization, and the strategy of going out.
No matter which policy/trend/vision is realized, it will be benefitial to the construction machinery industry. this is the “if the sun is not shining on the east, must be on the west” kind of margin of safety.
2. The valuation is low enough to reflect most possible bad situations.
Low valuation is an important source of margin of safety.
The future is always uncertain. Higher the hope, more disappointment there will be. Low valuation itself reflects low expectation for the future.
As long as valuation is low enough to reflect most of the possible bad situations, the likelihood that the future will be lower than expected is less.
Many people say that high risk, high return, low risk and low return. In fact, the margin of safety brought by low valuation is the best way to achieve low risk and high return.
A company’s worth is $1, you bought it for 50 cents. Even though you later found that the company’s valuation was 30% off, or that the company had an accident that hurt its value by 30%.
In both cases, the company is still worth 70 cents and investors are not losing money. This is the margin of safety associated with low valuation.
3. have “redundant design”, or “backup system” to limit downside risk.
Margin of safety is like redundant design in engineering. It usually seems redundant, yet it would found indispensable in the event of disaster.
For example, it is not enough for a nuclear power plant to have a spare power system. It is better to have a spare for the spare.
In real life, disasters that occur once in a century may occur in a decade; it is especially true in the stock market.
Taking risks can increase returns at many times. But one day you will find, “What goes around comes around.”
Zero times any number is zero, so be particularly careful against Ruin Risk.
Junk stocks are not backed up by “backup systems”, if they don’t have a bigger fool to hold the bag.
Foolish games, once played for a long time, attract more and more cheaters, will not have enough fools to continue. It is much better to look for margin of safety in the double insurance of low valuation and strong fundamentals.
4. value is easy to estimate, does not have reflexive nature, can buy more if it goes lower.
Companies with margin of safety usually do simple business, are easy to valuate, and not reflexive.
Reflexivity, as Soros calls it: a fall in the stock price itself has a negative effect on the fundamentals of the company, and tends to form a self-reinforcing vicious circle.
For example, a plummet in Bear Stearns’s share price can lead to a “run” by counterparties, which is reflexive. Therefore you should not buy more if it goes lower.
A plummet in Coca-Cola ‘s share price does not in any way affect its beverage sales. Thus, it is not reflexive. So, the lower it falls, the more you should buy.