This is part of my intermittent series on price, one of the most important and commonly encountered considerations in investing and trading. For this post, I will talk about the deemed “price” margin of safety (or price safety margin), and the accompanying concept called “freehold”.
I had mentioned about the price margin of safety in my post on Apple (post here). To have this margin in the first place, a position has to be initiated on a counter, which was selected based on one’s sound fundamental analysis. Subsequently, when the price moves up to its new level due to the company’s value or growth story, the margin is formed.
A few concepts can be derived from this “price” margin, a couple of which are psychological in nature. Let us have a look at these concepts.
Concept #1: “Freehold”
“Freehold” in some investors’ lingo meant that the initial capital on an investment had at least doubled, either through capital gain, or dividends or both. Since the investment had paid off itself, it is deemed as “free”, and the price margin of safety stands at 100%. While the thinking is purely psychological, the next step is what to do with these gains. If the growth story continues, then it could just sit there and continue to evolve to multi-baggers with a huge capital gain, or some or all of the gains can be redeployed, either on itself via averaging up (see Concept #2) or on other counters.
Concept #2: Averaging Up
If the belief of a continued growth story is there (with an analytical basis or “guesstimate”, of course), then one could continue to average up the counter. Though by averaging up, the price safety margin would be reduced, but overall it is still lower than the present price.
For example, let us say that one bought 100 shares of Company A at $10, and after a while the price rose up to $20, thus having this 100% gain. Since fundamentally Company A has a long way to go in its growth, an additional 100 shares were bought, thus making the average price at [(100 x $10) + (100 x $20)] / 200 shares = $15, which is lower than the present $20.
Concept #3: When The Going Gets Tough
Conversely, if the price is heading downwards, one would have to see his/her average price overall. Given the example in Concept #2, when the price of Company A falls to $18, there is still a $3 price safety margin as buffer ($18 - $15 = $3), and it would still be in an overall profitable position if the decision to liquidate is there, though some may comment the loss of $2 as an opportunity cost of not releasing it earlier.
However, when things get tough, one would also need to see the reason(s) behind the fall, and if the company is still fundamentally sound, then it is not an excuse to exit (unless he/she is one of those panicking investors that shouts “run for the hills” at the very sign of a price downtick), but rather a chance to do the opposite of Concept #2, which is averaging down. This is logical, for the price would most likely go back up, and in turn, create a larger price safety margin overall.
Concept #4: Coverage By Dividends
Relating back to Concept #1, the use of dividends to provide the price safety margin is based on the total returns equation, which is capital gains + income, where the income part are dividends. Supposedly, looking at the performance of a company’s share price, if the price remained constant throughout the past year, but it paid a 5% dividend yield at the same period, then it could be assumed that the price margin of safety is 5%.
It is not wrong to view it this way, though looking deeper we need to know why the share price did not budge; is it because there may be some future valuation issues, or is it because no one gives a hoot on this counter? The reasons could be varied and mixed, though not all are seen as negative.
As an active investor, one need to scan, scrutinize and scour one’s counters, whether inside the portfolio or on the watchlist.
Check out the other posts in my All About Price series.
All About Price: Introduction & Valuation of Value
All About Price: Buyer/Seller Remorse and Premorse
All About Price: The 52-Week High/Low
All About Price: Reversion To The Mean
All About Price: Bottom Fishing
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