Ch. 20 - Margin Of Safety

[DesertCat]

This is a very interesting chapter. Specifically Ben's manner of measuring a stock by earnings yield (he calls "earnings power"). It's the inverse of a PE ratio, so a stock with a 10 PE is yielding 10% and one with a 20 PE is yielding 5%.

This measure is important for comparing what value you are getting from buying stocks vs. bonds. Bonds held to maturity don't increase in value, the yield is all you get plus a return of principle. Stocks are volatile, when you sell you don't know if you'll get back your investment or not. So Ben's describing that excess yield over bonds as your "margin of safety" compensating you for taking that volatility risk, and should translate into higher total returns than bonds. Due to the great depression, for a long time common stocks were just viewed as extroadinarily risky and people were afraid they were just about to enter a 10 year bear market.

But as we've had a bunch of strong bull markets since the late 40s, attitudes have changed dramatically (back and forth even during the 70s). Now it's more common to view stock earnings as very likely to grow as the company grows while interest on the bond stays the same. So people bacame more accepting of a smaller premium of earnings yield over bond yields. This thinking drove the "Dow 40,000" and "Stocks for the long run" type of books that helped fuel the 1999 bubble. At one point the S&P 500, which is all large companies, traded at an average PE around 35, or a earnings yield of less than 3%. That's a great deal of confidence in the future earnings growth of those companies.

One of the most important concepts Ben gives you is to always look for a large margin of safety to compensate for your own evaluation errors and the haziness of future events. If you think a stock is worth $40, don't pay $39 for it, try to buy it at a price ($20?) so low that you can have great confidence that you will still do well, even if your evaluation is off by a little or business changes for the worse.

Lastly he gives some great principles. First don't try to make excess returns in the stock market unless you are going to treat it like a business, work at it like a business and know the values of your stocks just as well as you'd know the values of cars if you ran a car dealership.

Don't let anyone else manage your investments unless you can supervise them well or trust them implicitly.

Don't buy anything unless you know you're buying it a price that offers a positive expectation.

Ignore the crowd. If you've done your homework, stick to your guns. Always double check your assumptions, but let facts, not others opinions, change your mind.

[buffett]

Though Mr. Buffett recommends the entire book as the awesomest ever, he specifically points to chapters 8 and 20 as "all you really need to know."

PS
Lots and lots of thanks to DesertCat for taking the time to lead this book discussion. Great job all around.

[elus2]

[ QUOTE ]
Lots and lots of thanks to DesertCat for taking the time to lead this book discussion. Great job all around.

[/ QUOTE ]