On one of my previous post regarding Alex from Moneyvidya posed a question to me and I quote him

“Are margins of safety not based on intrinsic values which can only be estimated from the fundamentals. Do you know of a way to create or measure a margin of safety for an investment which protects you from the possibility that all your knowledge of the fundamental properties of the security are incorrect?”

I think one of the most important things in investing or in all aspects of our lives is to understand the concept of probability and the potential payoff arising out a probable event.

When we buy a lottery ticket lets assume the following structure

Scenario 1

Scenario 1

Price of ticket – Rs 1

No of participant - 100

Potential payoff = Rs 100 – Rs 10 ( Lottery provider’s fees) – Rs 20 ( Government taxes)= Rs 70

So for a probability of 1 in a 100 we have a potential payoff of 70 times.

The net payoff of this transaction is 1*(70) + 99*(-1) = -29

Most lotteries/ casinos are structured in such a manner where the participants lose money.

Scenario 2

Now let us assume that the lottery provider waived of his fees and the government its taxes and some benevolent donor added a extra Rs 25 to the kitty. Lets examine the structure now

Price of ticket – Rs 1

No of participant - 100

Donor contribution Rs 25

Potential payoff = Rs 100 + Rs 25 = Rs 125

So for a probability of 1 in a 100 we have a potential payoff of 125 times.

The net payoff of this transaction is 1*(125) + 99*(-1) = +26 times

In scenario 2 the odds are structured in our favour and hence a margin of safety is built in the trade. This need not necessarily mean that you will win the lottery but the odds are stacked in your favour.

Lets take this forward to stocks. When I evaluate stocks my starting point is management. What is the margin of safety in terms of management?. When I see a promoters personal yacht being put on the companies books it doesn’t necessarily mean the promoter will take the company down like Satyam but for me the odds are against me on this variable. There is a higher probability that the promoter will siphon out a bigger chunk on a latter date or indulge in corporate actions that is detrimental to shareholders.

I remember in one of my chats discussing real estate with one of my fellow bloggers and he telling me how can u expect ethical promoters in a business which is intrinsically unethical in India. It was a wonderful insight. So whether there is a problem today or not the odds are extremely high of encountering a black swan event in a real estate stock because of promoter action.

Will it happen? Not necessarily but the odds are stacked against you. To compensate for this is the margin of safety high enough on the financials in terms of intrinsic value to price and on a net off basis factoring both this variables is the odds in your favour.

Let us say that one has a portfolio of 10 stocks with positive payoffs on each stock. Lets look at the following structure

Number of stocks - 10

Probability of + returns on each stock - 60%

Probability of – returns on each stock - 40%

Can I eliminate a potential black swan event in a individual stock? The answer is no. To answer Alex’s question, we might encounter a black swan event in a single stock which cannot be eliminated but by building a margin of safety in each stock position one will on a overall portfolio basis achieve positive returns.

No of participant - 100

Potential payoff = Rs 100 – Rs 10 ( Lottery provider’s fees) – Rs 20 ( Government taxes)= Rs 70

So for a probability of 1 in a 100 we have a potential payoff of 70 times.

The net payoff of this transaction is 1*(70) + 99*(-1) = -29

Most lotteries/ casinos are structured in such a manner where the participants lose money.

Scenario 2

Now let us assume that the lottery provider waived of his fees and the government its taxes and some benevolent donor added a extra Rs 25 to the kitty. Lets examine the structure now

Price of ticket – Rs 1

No of participant - 100

Donor contribution Rs 25

Potential payoff = Rs 100 + Rs 25 = Rs 125

So for a probability of 1 in a 100 we have a potential payoff of 125 times.

The net payoff of this transaction is 1*(125) + 99*(-1) = +26 times

In scenario 2 the odds are structured in our favour and hence a margin of safety is built in the trade. This need not necessarily mean that you will win the lottery but the odds are stacked in your favour.

Lets take this forward to stocks. When I evaluate stocks my starting point is management. What is the margin of safety in terms of management?. When I see a promoters personal yacht being put on the companies books it doesn’t necessarily mean the promoter will take the company down like Satyam but for me the odds are against me on this variable. There is a higher probability that the promoter will siphon out a bigger chunk on a latter date or indulge in corporate actions that is detrimental to shareholders.

I remember in one of my chats discussing real estate with one of my fellow bloggers and he telling me how can u expect ethical promoters in a business which is intrinsically unethical in India. It was a wonderful insight. So whether there is a problem today or not the odds are extremely high of encountering a black swan event in a real estate stock because of promoter action.

Will it happen? Not necessarily but the odds are stacked against you. To compensate for this is the margin of safety high enough on the financials in terms of intrinsic value to price and on a net off basis factoring both this variables is the odds in your favour.

Let us say that one has a portfolio of 10 stocks with positive payoffs on each stock. Lets look at the following structure

Number of stocks - 10

Probability of + returns on each stock - 60%

Probability of – returns on each stock - 40%

Can I eliminate a potential black swan event in a individual stock? The answer is no. To answer Alex’s question, we might encounter a black swan event in a single stock which cannot be eliminated but by building a margin of safety in each stock position one will on a overall portfolio basis achieve positive returns.

## 6 comments:

Hi Ninad,

Sorry to post this here. Do you know any idea how to purchase Debuntures ,Warrants other Debt instruments ?

1) Active Trading is possible in Debt instruments or IPO is the only route ?

2)I am looking at TATA CAPITAL debunture..any idea where to get the prospectus ?

Thanks

Vishnu

Hi Vishnu

My response to the queries. This is my understanding

1) There is a debt trading platform on the NSE which however is largely made of institutional players and i dont think there is too much retail presence.

2) Tata Capital prospectus should be available in any of the finance shops that are there across the street or most banks as I think most banks are vending the debunture issue. This issue will be listed on the NSE and we would have trading opportunities at the retail level.

Trust this anaswered u r query.

Cheers

Ninad

Ninad:

Good simplistic explanation! I like the use of examples to convey the point.....

I also agree, black swan events just cannot be captured in any analysis....

Best Regards,

Ninad,

Thanks for the response in this post. I would have left this comment earlier but have been incapacitated by a suspect pineapple juice for several weeks.

I like the concept of a "margin of safety with regards to management" which I think in India is massively important. I also agree that in the realty sector you're unlikely to find it because of the way the business operates.

You argument if you have sufficient margin of safety in each stock then although this may not help avoid a black swan event, it does allow you to survive it at the portfolio level, is an excellent one.

Cheers,

Alex

Hi Alex

Trust you are back in health. I have been off the blog also for the last few months caught up on work.

Cheers

Ninad

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