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 dollar selling for $0.50. 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, seeking a margin of safety will determine whether investors ultimately swim or sink.

Just look at the mortgage crisis. Countrywide Financial shares traded around $40 each one year before Bank of America (NYSE: BAC  ) bought it out. 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 single digits that Bank of America paid.

Then there's WCI Communities, the luxury Florida homebuilder. After the company rebuffed Carl Icahn's $22-per-share takeout offer in 2007, the stock fell to $10. It now sits in the Pink Sheets at around $0.06.

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 it 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 a 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 under their book values realizes my point. Hovnanian (NYSE: HOV  ) now trades at a little more than one-half its book value, Beazer (NYSE: BZH  ) at just over a tenth, and so on down the list.

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 may or may not be buying at the bottom. But that should be of no concern to you if you 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. If you can't work through the effects of JPMorgan Chase's (NYSE: JPM  ) purchase of Bear Stearns, or figure out the toxicity of Citigroup's (NYSE: C  ) loan portfolio, stay clear.

Two, look at well-known, more-established companies selling cheaply because of temporary problems. For example, retailers like Sears Holdings (Nasdaq: SHLD  ) and Gap (NYSE: GPS  ) have been taking hits due to the poor economy. But many of them will recover nicely once the economy rebounds.

Once you 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, 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 need only to have patience and conviction in their analysis.

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Dan Caplinger updated this article, originally written by Sham Gad and published on Nov. 9, 2007. Dan doesn't own shares of the companies mentioned. JPMorgan Chase is a Motley Fool Income Investor recommendation. Sears Holdings is a Motley Fool Inside Value selection. Try any of our Foolish newsletters today, free for 30 days. We'll show you how to turn panic into opportunity. And not just in some touchy-feely way. The Fool has a disclosure policy.


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