The Indian equity markets have been pretty volatile since the beginning of this calendar year. While there are several variables acting in tandem -- like US interest rates and volatility on the FII inflow front and domestic and global politics -- what this ultimately means is that times have become riskier for retail investors.
Now, what is this risk we are talking about?
In the current times, when the markets are quite volatile, risk can well be associated with paying a higher price for a stock that does not justify value of the holding or that already factors in the growth for the next few years.
And in these times, it is an imperative for stockbuyers to give heed to one of the breakthrough concepts of investing given by the 'father of intelligent investing,' Benjamin Graham.
Known as the 'Margin of Safety,' this concept has been (and is) very essential while investing in stock markets. This concept, generally, applies for other investment avenues like bonds.
For instance, a company must earn a pre-tax profit of more than five times the total interest cost for its bonds to qualify as investment-grade issues. In simpler words, if a company 'X' has interest charges of Rs 10 per annum, it should make Rs 50 as profit before tax for its bonds to qualify as investment grade instruments.
The excess of profit after paying interest provides a sense of comfort for investors. And this is called the 'margin of safety,' which acts as a protection to investors against any loss in the event of some future decline in net profits.
Now, can this concept of 'margin of safety' be applied to common stocks (or stocks)? Graham says yes, but with some modifications. For ordinary stocks, the margin of safety lies in an expected 'earning power' considerably above the interest rates on debt instruments.
Simply calculated, earning power is equal to the reciprocal of P/E ratio, i.e., E/P. For example, a stock with a P/E ratio of 8 has an earning power of 1/8, or around 12%. In common parlance, this is often known as the 'earnings yield.'
Considering the above example, assuming that the stock has an earning power of 12% and that interest rates on a 10-year bond is 5%, then the stockbuyer earns an excess of 7% over bond, which is a margin in his favour. While such bargains are hard to find in these times, the level of margin a stockbuyer considers safe is dependent on his ability to take risks.
However, having a stock with a high margin of safety is no guarantee that the stockbuyer would not face losses in the future. Businesses are subject to various internal and external risks, which may affect the earnings growth prospects of a company over the long-term.
But if you have a portfolio of stocks selected with adequate margins of safety, you minimise your chances of losses over the long term.
In this context, stock selection is of great importance. Now, while losing some money is an inevitable part of investing, to be an intelligent investor, you must take responsibility for ensuring that you never lose most of all of your money.
Equitymaster.com is one of India's premier finance portals. The web site offers a user-friendly portfolio tracker, a weekly buy/sell recommendation service and research reports on India's top companies.
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