Protected by Margin of Safety - A value investor's 'airbags'.

By early 2009, I had bought most of my stocks that I held today. My portfolio during early 2009 included stocks like CapitaCommercial Trust, MacArthurCook Industrial REIT, Parkway Holdings, Tat Hong Holdings, Keppel Corp, Jaya Holdings and STI ETF. I kept to less than 10 stocks adopting a focused investing approach since I was determined to pick up skills in analysing businesses, and I will only hold stocks that I find after analysis that have good continuing business economics in the long run. There is no need to hold too many stocks (more than 10 stocks) since I only need a few big winners in my portfolio to achieve good returns.

Diversification is for investors who do not want to or do not know how to get involved in knowing about the underlying businesses of their portfolio stocks. As such, these investors are better off with diversifying into owning more than 10 stocks so that some may generate returns while others losses and it may still provide the investor with average returns in the long run. He may also consider investing in exchange traded funds (ETF) which also offers diversification to achieve average returns. At least diversification is a conservative approach which may still yield average returns suited to the "know not" investor.

However, since I was determined to be a focused value investor, I had to learn more about focused value investing. Focused investing requires me to learn how to evaluate businesses. This will help me to select only stocks of a few good businesses to invest in since my funds are focused in only a few businesses. I shall discusss more of my experiences on learning how to evaluate businesses in later posts. To some, focused investing may sound risky. What makes one thinks he can be absolutely correct about a business's long term potential? What if he makes mistake in his evaluation and invested in a lousy business, he will have to incurr larger losses since he will have more funds invested in every selected businesses? Yes. Focused investing is one of the best ways to achieve greater returns than STI index benchmark. However, there is a flipside to it. It magnifies returns and also magnifies losses as well since there is no diversification.

Focused investing will not be complete if there is no value investing approach. It will be like a body without limbs. Both focused investing and value investing are intertwined together and complement each other. One cannot do without the other. Therefore, a more appropriate way to call this excellent method of investing is "Focused Value Investing". Focused means focusing on evaluating and investing in businesses with great business economics. Only a few businesses is selected since the selection process must be rigourous. Not any business can be selected for investment. A focused investor only constantly seeks the best few businesses around for investment investing heavily in such few businesses. Value investing means only investing in such few excellent businesses at undervalued prices.

I shall focus my discussion on value investing and concept of margin of safety. An investor can peg a fair stock price for every stock. This can be a subjective affair since not every investor perceive the underlying business of the same stock in the same ways. The business underlying the stock maybe perceived as average performing to one investor but high performing to another. It all depends on what measurements each investor uses to evaluate the business. There are just too many measurements and ways to go about evaluating a business that this affair of business evaluation is more of an art than science. This is also what captivates me most (the thrill of evaluating businesses).

When a value investor has determined after analysis a fair stock price for a stock, he then seeks to invest at only below this fair stock price (or sometimes called intrinsic value of stock). By doing so, he buys the stocks only when its stock price is traded below its intrinsic value. This will make it a bargain buy. Another important note is that by buying at bargain prices, an investor is also buying the stocks at a margin of safety (this importance is usually underestimated).

I bought stocks of Jaya Holdings from October 2008 to April 2009 after some evaluation of its business. I perceived it as having an excellent track record (high consistent EPS, ROE and profit margins, high dividends and consistently increasing shareholders' equity value). As I bought more of this stocks over early this year, my average holding price was around $0.30 per share. When news of the difficulty in refinancing its business came, its stock price dropped drastically from around $0.60 plus range to close to $0.30 plus range. Then, came news of impairment losses on reducing some of its vessels that it intends to build. This resulted in its net profit for the most recent year plunged heavily until around making only 1 to 2 % net profit for the year. Thankfully, revenue and profits from its support vessel chartering business is still growing and prevented the company from making a potential loss.

I decided to divest this stocks after considering that there are better companies around to invest (e.g. companies with net cash position in their war chest or low gearing). I had the ease of exiting this stocks at around $0.40 plus range and still made a small profit on divestment. Whether I had made the right choice of exiting this stocks, only time will tell. However, my ability to divest without making a loss was due to the fact that I had pursued a low average holding price giving me adequate margin of safety. I was protected from the sharp fall in price due to a margin of safety made only possible by buying at as low price as possible below the intrinsic value of the stocks (fair value of the stocks). This is akin to driving with airbags installed (holding stocks at low undervalued prices) providing a margin of safety from getting hurt in car crashes (sharp fall in future stock price). One does not want to have car crashes or sharp fall in stock price. However, it pays to be prepared for this uncertainity which may come without knowing.

Of course, buying at undervalued prices below what a stocks is worth not only offers a margin of safety. It also provides potential for greater long term returns since one is paying less to receive the total net earnings or total free cashflows a company can potentially generate over a period of time.

Discussion points:- Focused value investing is a total approach. Focus one's energy and capital on evaluating and finding a few great businesses to invest heavily in. Invest heavily in such few excellent businesses by paying less for their great value (value investing). These two approaches complement and is interdependent on each other like the body and its limbs.

Value investing has two benefits. It provides a margin of safety to buffer against future drop in stocks price. It also allows the investor to pay less to receive the total net earnings or total free cashflows a promising company can potentially generate over a period of time.