SPECIALS
Building a Margin of Safety

By Maynard Paton (TMFMayn)
November 22, 2001

Earlier this year, investment bookshop Global-Investor approached 150 of the world's most respected financial experts and asked them each to provide ten 'rules' for stock market success. Global-Investor subsequently published their responses in the book "Investing Rules". Writing in The Sunday Telegraph, Luke Johnson described it as "almost certainly the most useful financial book published all year." The Motley Fool agrees. No matter what stock market strategy you favour, you're bound to find the rules that suit your investing aims.

To give a flavour of the book, we're publishing the guidelines from five of its contributors. This feature covers the thoughts of Jim Slater and "Building A Margin of Safety".

Jim Slater: Building a Margin of Safety.

Jim Slater was Chairman of the legendary financial conglomerate Slater Walker Securities. He is the author of five investment books, including the famous Zulu Principle. He devised Really Essential Financial Statistics (REFS), and acted as launch editor of the Investing for Growth newsletter.

1. Develop a method that suits you.

Carefully select a method of investment and then, based on personal experience and the performance of your portfolio, hone, temper and refine it until you are satisfied beyond doubt that it works for you. As you become more expert, you can use several different methods at the same time according to market conditions

2. Establish a margin of safety.

Any method, whether it's growth or value, should be based on establishing a margin of safety -- a cushion between the amount you pay for a company's shares and the amount you believe they are worth. The attraction of building a margin of safety is that it helps to protect against downside risk and at the same time provides the scope for an upwards re-rating.

3. Adjust the margin of safety to your approach.

For growth stocks, a typical method embracing a margin of safety would be to seek out shares with strong earnings growth records and a relatively low price to earnings (P/E) ratio in relation to their future growth rates. Ideally, the growth rate should be at least one third more than the P/E ratio. To increase the safety factor, it is also highly desirable for the company to have a record of strong cash flow in relation to earnings per share and a strong balance sheet.

For value stocks, the margin of safety can be established by a low price to sales ratio, low price to book value and strong cash flow. Also, with many undervalued asset situations, it pays to look for recent relative strength and recent directors' buying which can be signals that a company is about to turn around.

4. Keep an eye on significant share dealings by directors.

Directors' buying is frequently linked to a change in a company's fortunes, especially if the directors are buying a significant number of shares in a cluster of three or more. Equally, directors that sell large tranches of shares are often warning signals and should put you on red alert.

5. Judge management by their numbers, not by their manners.

The ability of management is very hard to quantify. If you go to see them or meet them at a presentation, they naturally put their best foot forward. Management can best be judged by several years of good results with brokers' forecasts confirming that they are likely to continue. The financial results are the best judge of management, not the people going to see them.

6. Look for positive relative strength to corroborate your view of a share.

Shares that perform well in the market are often winners in the making. With growth stocks, relative strength in the previous twelve months should be positive and certainly greater than the one-month figure. O'Shaugnessy found in What Works on Wall Street that relative strength was, in most years, the best single investment criterion.

7. Run profits and cut losses.

This is much easier said than done, but it is far better practice to add to winners and pare down holdings that are not performing well. This way, your losses will always be small and your gains can be gigantic. Remember that the power of compounding is the eighth wonder of the world.

8. Never stop learning.

There is always a faster gun, so keep reading books on investment by well-known and established experts, attend investment conferences and consider joining an investment club. Also make sure that you have a regular source of sound statistical stock market data. In the UK, Company REFS does, of course, come to mind!

9. Be tax efficient.

Use annual capital gains tax allowances, PEPs, ISAs and a personal pension scheme to the maximum possible extent.

10. Don't kid yourself.

Do not be fooled by your own excuses. Measure your investment performance honestly and regularly and if, over a year or so, you find that you are not consistently beating the market, delegate to an expert manager or invest in a unit trust or tracker fund and use your surplus time and energy elsewhere.

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