Intrinsic Value vs. Market Value

In his classic book Margin of Safety, author Seth Klarman defines value investing as "the discipline of buying securities at a significant discount to their underlying value and holding them until more of their value is realized."

His definition points to the key of the value-investing process -- finding bargains. Value investors are always on the hunt for a 50-cent dollar. And that means value investors become very attentive during times of fear and panic.

However, they also won't overlook the need for a margin of safety. In fact, with so many companies earning a spot on the 52-week-low list lately, the process of seeking out a margin of safety will determine whether investors ultimately swim or sink.

Just look at the mortgage crisis. Countrywide Financial (NYSE: CFC  ) sat at $40 a share at the beginning of the year. When it approached $20, it may have looked like a bargain. After all, the biggest originator of mortgages had to bounce back, right? But the stock kept falling, down to the $12 range.

Then there's WCI Communities (NYSE: WCI  ) , the luxury Florida homebuilder. After the company rebuffed Carl Icahn's $22-per-share takeout offer, the stock fell to $10 and now sits at around $4.

We've all heard investors rationalizing that when a stock price gets so low, it surely can't go any lower. Thinking about a stock in this manner is misguided and usually leads to financial pain. After all, until a stock price has reached zero, it can always go lower. It's crucial to understand that with the sudden negative fundamental shift in the operating environments of these businesses, their intrinsic values have changed.

Intelligently assessing intrinsic value is difficult, given the current unknowns surrounding the credit markets. Therefore, an investor should demand a greater margin of safety to compensate for the increased uncertainty. If that's not possible, the investor should abandon the security until he or she has a better view of things.

Anyone who was buying homebuilders based on the premise that they were selling at half of their book value realizes my point. WCI now trades at about one-fifth of book, Hovnanian (NYSE: HOV  ) at about one-third, Beazer (NYSE: BZH  ) at about one-fourth, and down the list we go.

Margin of safety
Investors also need to see the difference between Mr. Market's price and the value of a business. In today's environment, you will not be buying at the bottom. But that should be of no concern to you if are investing with a satisfactory margin of safety.

How do you find an acceptable margin of safety? For one, avoid messy balance sheets. Leave companies with lots of debt to the more sophisticated, deep-pocketed investors. Two, look at well-known, more established companies. For example, Washington Mutual (NYSE: WM  ) recently took a 17% dive on news of much lower future loan originations and higher loan-loss provisions. At $19 a share, Washington Mutual is trading at a price unseen since 2000.

To be fair, WaMu is also living through an operating environment unlike any other, so there still could be more pain ahead. Yet the likelihood that WaMu will go out of business is extremely low. Aside from its lending operations, it also operates retail-banking and credit-card segments. I haven't looked into this company, so I can't say it's a bargain at this point, but Mr. Market has certainly gotten more emotional about it over the past months.

Once you do have a great business selling at a good price with a satisfactory margin of safety, don't panic if the stock price drops after you buy. Changes in stock price have nothing to do with risk. And if you have indeed secured your margin of safety, then you should heed the following words of wisdom from the partners of value investing firm Tweedy Browne:

One of the many unique and advantageous aspects of value investing is that the larger the discount from intrinsic value, the greater the margin of safety and the greater potential return when the stock price moves back to intrinsic value. Contrary to the view of modern portfolio theorists that increased returns can only be achieved by taking greater levels of risk, value investing is predicated on the notion that increased returns are associated with a greater margin of safety, i.e., lower risk.

After taking such an approach, investors only need to have patience and conviction in their analysis.

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