The following is a guest post by Saj Karsan of Barel Karsan, a site dedicated to finding and discussing current value investments.[ad#tdg-embedded]
Warren Buffett calls Benjamin Graham’s The Intelligent Investor “by far the best book on investing ever written”. (A chapter-by-chapter summary of this book is available here.) Buffett studied under Graham while enrolled at Columbia Business School in 1950.
The most important idea that Graham put forth in his teachings was the concept of a “margin of safety”. Once an investor has estimated the worth of a company, he should only purchase it if it is trading significantly below (e.g. at half the price) of that value. This required discount is called the margin of safety. It protects investors from losses by allowing room for error in the investor’s calculation of the business’ value, while at the same time offering potential for excellent returns.
Applying a margin of safety is simple enough, but how does one go about putting a value on a business when the future is uncertain? One of Graham’s favourite methods to determine the minimum value of a company was to calculate its net current asset value. This is done by taking the company’s current assets (cash, receivables, inventory etc.) and subtracting all of its liabilities (debts, pension obligations etc.).
Using this method of valuing a business assumes the company will earn no money in the future, which is very conservative. Furthermore, by applying a margin of safety to this value, investors are further protected.
Historically, it has been difficult to find companies trading at such discounts to their net current assets. However, the market turbulence of the last year has increased the number of companies that make this list. Hardinge represents one example of a company we’ve discussed that is still trading at a discount to its net current assets. For some other recent examples, see here.
While nobody can predict the future with certainty, by applying conservative valuation methods and by applying a margin of safety, investors simultaneously reduce their downside risk and increase their upside potential. Applying this method to a diversified group of stocks is expected to result in better-than-average long-term returns.
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