Defensive Investing
There are three topics we will cover and connect together for a defensive play.
Anti-goals, what not to do.
Margin of safety
Fair Value
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When you were a kid, you were probably asked “what do you want to do when you grow up?” Your answer was mostly the coolest work/play you saw last. A cricket player, doctor, driver. List is endless.
Now if someone asks me what I want to do my answer is always the same “I don’t know”. 😾
But if you ask me what I don’t want to do, I can list out a number of things. I don’t want to
work in a 9-5 job
invest for short term
take a loan
and lot of other things .
For investing your money and your most precious resource, time, you can think similarly. What you don’t want to do. 🚫
A yatch getting permanently destroyed. In investing you can never ever destroy your capital permanently. That is one anti goal you can always follow.
Margin of safety is a tool which can help you with this.
You use this every day. Don’t believe me?
Ok imagine this. 🚗
You are driving a car in highway. Oh wait maybe you don’t drive a car. Then imagine sitting in passenger seat beside the driver.
You are cruising at 100km/hr and the road is relatively open. Less cars, bikes and trucks.
Enjoying this cool ride, you see a car just in front of you going at almost the same speed as you. If you overtake, it wouldn’t benefit since you will come back down to 100km/hr cruising speed. So you decide to follow the car.
And at this moment you unconsciously put margin of safety into play. How? When you decide to follow the car, you would put a distance between you and the car ahead of you.
Why? Because if the car ahead slows, you get comfortable time to put breaks as well. This will give you those few precious extra seconds to act and avoid crashing.
The distance is the margin of safety.
Now let’s see how it looks like in investing.
You find a good stock with good fundamentals and management. All that remains is to invest in your bet.
So you look at current price. It is X ₹.
Is it cheap or expensive? Looking at its potential you know from your gut that it seems cheap at its current price.
But what is the safety? How much distance do you have if you buy at this X ₹?
A car on highway with lot of safe distance. To find out that, you need to estimate a fair value for the company. How to do that? That is an art. It’s something you have to find out after practice. Here’s a simple calculation you can start with
Take median PE of 10 years. Get an estimate of earnings growth rate for next 5 years. Get an estimated EPS. Multiply estimated EPS with median PE.
The challenge is to find the estimate without bias. This requires you to research and verify all the claims company is making.
Woops. Too much detail for one issue. And you still haven’t seen how to get the distance. Don’t worry just few lines more. It is simply
where
mos = margin of safety
fv = fair value
cp = current priceIf mos is negative then it is a big danger. If a small distance, like +10-20% from current price, then its also problem. Because if your estimations are few points away, you loose money.
So to preserve and avoid permanent loss of capital, you need to have a good margin of safety at the price you are buying.
Do you want more clarity on long term investing? Reply to this email and I will get to you ASAP.
The challenge is to find the fair value. It is based on your estimations and bias so you need to be careful. This is something only practice can make you better.