How to find Investment Ideas with a Margin of Safety

How to find Investment Ideas with a Margin of Safety

As a follow-up to yesterday's post, remember at times of emotional extremes it pays to be contrary. The great irony of the current sell-off is that it presents an investor who can stand aside from the mania of the crowd, an opportunity to buy the stock's of good companies on the cheap. The price you pay for these companies will have a built-in 'margin of safety.' And in the long run that is what the game is largely about.

The best investment opportunities usually come in big waves, such as when the entire market declines. Big sell-offs in the market can cause forced selling. When this happens money managers are forced to sell the stocks in their funds because of client redemptions who panic at all the bad news and just want to liquidate their holdings as fast as they can (the herd effect of the crowd). The fund managers may know that they’re selling under-valued securities but they have no choice. This can create a vicious feedback-loop effect where indiscriminate selling begets more selling, as some stocks will just be dumped for reasons that have nothing to do with the companies underlying fundamentals. Hedge funds that use leverage are even more susceptible to this forced selling as they no longer can make their margin calls and are forced to dump everything so they can raise liquidity. The solitary investor, who can stand aside from the galloping herd of the market, can take advantage of the situation and cherry pick the low hanging fruit the market is offering him.

The beauty of forced sellers is that they have no choice. They have to sell regardless of price. If chaos is widespread, many people will be forced to sell at the same time and few people will be in a position to provide the required liquidity. The difficulties that mandate selling – plummeting prices, withdrawal of credit, fear among counter-parties or clients – have the same impact on most investors. Prices can fall far below their intrinsic value. This can cause an imbalance between the sellers and buyers in the market place. It can be a scary time but an alert investor who puts an emphasis on the importance of his purchase price can buy things at this uncertain time which will have a built in ‘margin of safety’. So ironically at a time of seeming danger and fear an investor with the right disposition can actually do the safest thing in the long run and buy cheap.