| Century Management's Four Principles of Successful Investing
1.
Always Use a Business Approach
2. Always Use a Margin of Safety 3. The Market Acts Like a Manic-Depressive 4. Price Determines Return Principle #2 - Always use a Margin of Safety. Using a "Margin of Safety" allows us to create a favorable risk and reward scenario. It allows us to put the odds in our favor. We like to buy companies with $5 of reward for every $1 of risk. An understanding of the Margin of Safety, can be illustrated in the following analogy. If you build a bridge that requires enough strength to support a 15 ton truck, why not build it so it can support a 30 ton truck? After all, we never know when a 30 ton truck will need to cross the bridge and, if it does, we will be protected with a 50% margin of safety. A Margin of Safety means that rather than pay retail (which is too much) for a company, we buy the company at a wholesale price. In other words, we only invest in a company when there is an opportunity to buy it at a 50% to 75% discount from its Private Market Value. The reason investing at the wholesale level is so important is that if one pays retail for a company, there is no room for error. The Margin of Safety helps protect us from earnings surprises, competitive pressures, higher interest rates, inflation, war and the many unforeseen future events that are out of our control. How and why does a stock sell at 50% to 75% of its Private Market Value? Let's look at a rental house. If your rental house is worth $100,000 and you have a tenant from whom you are getting $10,000 per year (after expenses) in rent, you are earning a 10% return. Now suppose the tenant calls one night and says he is breaking the lease and moving out. This is an earnings surprise but does it mean that your house is now worth 50% less ($50,000) because you'll lose rental income (earnings) for the next quarter or two while you are looking for a new tenant? Of course not. As a property owner you are aware of your house's Private Market Value and the temporary loss of income does not change the long-term value of the house. In the stock market, this happens everyday, because uninformed sellers do not know the true Private Market Values of the holdings in their investment portfolios as well as they understand the values of their homes. If we are able to buy the above rental house for $50,000 from a panicked, uninformed and emotional seller and then proceed to lease it out for $10,000 per year, we would have a 20% return on our investment. This a good example of an investment made at 50% off the Private Market Value. This is putting the odds in our favor by giving us a Margin of Safety. Note, that when the investing public over-pays for a company, often times they are forced to become long-term investors just to get their money back. Use the Margin of Safety! |