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 INR 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 INR 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 INR 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 INR 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.
Narach INVESTMENT
