We will be discussing a few key topics in this final chapter that can significantly affect how you make investment decisions. In the previous chapter, we learned how to calculate the intrinsic value using the Discounted cash Flow (DCF). The DCF method is one of the most reliable ways to determine a stock's intrinsic worth. The DCF method does have its limitations, which you should be aware of. The DCF model can only be as good as the assumptions it is fed. The fair value and stock prices computations could be affected if the assumptions are wrong.
Because the DCF model is based upon certain parameters, it can also cause you to miss out on unique opportunities.
The only way to overcome the DCF Model's drawbacks is to be as conservative as possible when making assumptions. These guidelines are for conservative assumptions:
Even though you make some cautious assumptions, there is always the possibility of things going wrong. How can you protect yourself from that? Here is where you will find the concept of "Margin of Safety". Benjamin Graham, a seminal author titled "Intelligent Investor", popularized the margin of safety thinking process. The margin of safety suggests that investors should only buy stocks when they are available at a price lower than the estimated intrinsic value calculation. The Margin of Safety is not an indicator of success in investing but it can be used to help avoid mistakes when calculating.
Here's how I apply the 'Margin of Safety principle to my own investment practices. Amara Raja Batteries Limited's intrinsic value estimate was approximately Rs.368/share. To create the intrinsic value range, we used a 10% modeling error. The lower intrinsic value estimate was Rs.331/. We are accounting for modelling errors at Rs.331/- Margin of Safety recommends that we further discount the intrinsic value. I like to reduce the intrinsic value by at least 30%.
It is important to not discount it any further. Aren't we extra conservative, you may ask? This is how you can protect yourself from bad assumptions and bad luck. If a stock is attractive at Rs.100 and then at Rs.70, it can be a safe bet. This is what value investors who are savvy do.
Let's go back to ARBL.
Value investors will pick up quality stocks that are significantly below their intrinsic value. If you have the margin of safety, you should buy it as soon as possible. Sweet deals such as this, where a stock is trading below its intrinsic value, are a great deal for long-term investors.
Remember that stocks with good prospects will be at great prices, especially in bear markets when stock market pessimists are very negative. You should ensure you have enough cash to shop during bear markets!
We have covered buying stocks throughout the module. What about selling stocks? How do we book profit? Let's say ARBL was bought at Rs.250 per share. It now trades at Rs.730/share. This is a 192% absolute return. This is a great return rate, especially considering that the return was generated in just over a year. Does that mean you can actually sell this stock and make a profit? The disruption in investible-grade attributes will determine whether you decide to sell.
Disruption of investible-grade attributesRemember that the stock's price does not determine whether or not you buy it. ARBL has not fallen 15%, so we don't buy it. ARBL is only bought because it meets the criteria of "investible grade attributes". We will not buy stocks that lack investible grade attributes. This logic dictates that we keep stocks so long as they have investible grade attributes.
The same attributes can be displayed by the company for many years. We will continue to invest in the stock as long as these attributes remain intact. These attributes will naturally increase the stock price, creating wealth for you. If any of these attributes show signs of deterioration, it is time to sell the stock.
There is much debate about the number of stocks you should own in your portfolio. Although holding many stocks can help you spread risk, some argue that holding fewer stocks will allow you to make concentrated bets which could reap huge rewards. This is what legendary investors have said about the importance of having a small number of stocks in your portfolio.
Seth Klarman – 10 to 15 stocks
Warren Buffet - 5-10 stocks
Ben Graham - 10-30 stocks
John Keynes - 2 or 3 stocks
My personal portfolio currently contains 13 stocks. I wouldn't be content with owning more than 15. Although it is difficult to say how many stocks you should own, I think there is no reason to have a lot of stocks in your portfolio. Large is a number that I consider to be over 20.
We have covered many topics in the markets and fundamental analysis over the 16 chapters. It is time to say goodbye and let me leave you with some last points I believe are important.
Let me leave you with four book recommendations to help you build a great mindset for investing.
These are my points and I'm going to close the Fundamental Analysis module. I hope you enjoy it as much as I did while writing this article.