Margin of Safety and when to sell

Hi,

I have previously asked whether the 70% intrinsic value % cutoff already included the margin of safety and I was given a positive answer. Now I realize I am not really clear on this point and where the margin of safety is built into in the formula.

My understanding from the intelligent investor was that let's say a stock has an intrinsic value of 10$. That's the value it should be trading it if it was fairly priced. But in order to have a margin of safety in case the market does not recognize their mistake, I will only buy it when it drops below 7, leaving a 1/3 margin of safety.

Now I understand from you that the formula already incorporates the margin of safety + there is an adjustment for bond interest rate compared to Ben Graham time, which makes for example for the US stock such that the right price for the stock with adjusted interest is the one that make a 70% intrinsic value %, and that includes margin of safety.

In other words, if stock trades for 10 and it's intrinsic value is above 7, that would be okay. Can you break down how this is derived? Many thanks.

Then, having established this, following the work of Ben Graham, the intelligent investor would no longer have much of an interest holding the stock once it has reached or better - exceeded - its fair value.

So now we have the intrinsic value at 7, my purchase price at 10. What would be the fair value to sell? How do I calculate the point where the stock becomes 'overvalued'. Is it as soon as the ratio drops below 70%?

Thanks

Submitted by rc2752. Created on Tuesday 11th August 2020. Updated on Tuesday 11th August 2020.

Submitted by GrahamValue on Tuesday 11th August 2020

Dear rc2752,

Thank you for your forum post!

The Margin of Safety is essentially an abstract concept that is central to the idea of Value Investing.

But Graham did not mention any requirement for a further discounting in the framework given in the Stock Selection chapters of The Intelligent Investor. He does mention that the framework is based on Bond Yields, but the calculations he gave were already tailored to the existing Interest Rates at the time.

The only time he mentions any kind of additional discounting is in his Two-Thirds NCAV strategy, but only in reference to his own operations. Again, the framework he finally gave his readers included calculations with the Margin of Safety built into them.

Example

When you say above that the Intrinsic Value of a stock is $10 based on Graham's calculations, that price already has the Margin of Safety built into it.

But since Bond Yields today are lower than they were during Graham's time, the Intrinsic Value would need to be adjusted by increasing it by the Square Root of the ratio to prior Bond Yields (as explained in the link on Bond Yields above).

Note that a lowering of Bond Yields will increase Intrinsic Values, and not decrease them. A lower permissible Intrinsic Value(%) on Serenity indicates that stocks with higher prices become eligible for investment, implying that their Intrinsic Values are higher than what Graham's original calculations indicate.

Interest Rates ≈ Gravity

As Buffett and Munger have often said, it helps to think of Interest Rates as gravity to stock prices. When Interest Rates or Bond Yields fall, stock prices rise.

So now, let's assume here that you buy the said stock under $14; the Intrinsic Value adjusted for Bond Yields. Based on Graham's instructions on selling for Value Investors, you would either wait till the stock rises to above $14; or until you have something better to invest in, after adjusting for any tax and brokerage costs.