Thursday, May 26, 2011

Margin Of Safety Example

You're not going to nail every investment. The odds may not be on your side (even if you think they are, which is why you invested) or even if the odds are on your side, your investment can still be derailed. But thanks to the all-important margin of safety, you can still do allright even if things don't go as well as you expected.

As an example, consider Audiovox (VOXX) which had been on the Stock Ideas page for 1.5 years. The company was a perennial earnings under-performer, relegating it to a low price-to-book market valuation. Investors were offered the company at a large discount to net current assets, so if all the company did was sell its inventory, keep expenses reasonable and return cash to shareholders (not exactly high hurdles), shareholders would make out very well.

While the company was able to accomplish the first two of those requirements successfully, it balked on the third, opting instead for an empire-building acquisition that converted cash into potential future earnings. An event of this nature was certainly a risk, as this was a situation where a shareholder controlled the company without having to put up the capital commensurate with such a stake, thanks to a dual-class share structure. As previously discussed, this share structure can result in poor results for non-controlling shareholders.

But because of the large margin of safety on this investment over the last couple of years, shareholders who bought in at a discount to assets didn't get burned on price. They may have felt like Audiovox's business value dropped, but its market price has actually increased as the shares were far too cheap. So despite a continued poor operating environment, sub-par returns on capital, and an acquisition binge, shareholders in Audiovox still generated double-digit returns over the last 1.5 years.

Speculators, traders, and other short-term market participants aren't buying businesses. They are buying expectations. Just like value investors, they can be right in their assertions or they can be wrong. But the nature of short-term speculation is such that one cannot employ a margin of safety, whereas that is the value investors greatest advantage. The margin of safety can cause value investors to be right even when they are wrong.

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