"Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions." —Benjamin Graham from Chapter 20 of The Intelligent Investor



The above quotation demonstrates the peril of buying a stock without a sufficient margin of safety. Anyone who does not admit to having made that mistake is either a compulsive liar or a serial money market investor. Buffett has been quoted as saying the three most important words in investing are margin of safety and Seth Klarman felt the concept was pertinent enough to make it the title of his book. If you have an extra thousand that is not working you can buy a used copy of "Margin of Safety"on Amazon. http://www.amazon.com/Margin-Safety-Risk-Averse-Strategies-Thoughtful/dp/0887305105/ref=sr_1_1?s=books&ie=UTF8&qid=1301533012&sr=1-1



The concept of margin of safety is directly associated with avoiding a debilitating loss on the purchase of a common stock or any other security for that matter. Avoiding a permanent capital loss on an investment, as defined by losing 90% or more of your purchase price, is paramount to achieving acceptable long term returns. If an investor suffers a permanent capital loss on an individual stock, he needs an equally weighted two-bagger in another stock just to get back to even. Successful investing is more of a game of defense than anything else. Avoid excessive losses and the gains will take care of themselves, so long as one is purchasing securities at a discount to their intrinsic value.



Enough generalizations, how does someone such as myself without the insight and analytical skills of Buffett, lacking the wisdom and research team of Klarman, buy with a margin of safety? I follow the lead of Walter Schloss, using tangible book value as my key metric to determine a margin of safety. All the better if I can locate a stock that trades at a discount to its current assets (current assets less total liabilities > than marketcap). Better yet, the creme de la creme of margin of safety, a stock that trades at a discount to cash, cash equivalents, and marketable securities (cash+cash equivalents+marketable securities-total liabilities>marketcap). I look for a minimum of a 25% discount to tangible book when defining a margin of safety. My serious purchases generally involve closer to a 50% discount, preferably with a large percentage of that discount in the form of current assets.







I generally buy tiny companies which are under followed and frequently overlooked by most investors, a process that Buffett utilized in the late '50s and early '60s to accelerate his accumulation of wealth. I suggest that everyone read the Buffett Partnership Letters from 1957-1970—they are full of insight on investing in microcap companies. Search the internet and you will find them.



An example is in order: During the Summer of 2009, Wall Street was offering up shares of a certain machine tool company at a tantalizing discount to its net current assets. The company was Hardinge (NASDAQ:HDNG). They had existed since the early 1900s and had been recapitalized in 2007 near the height of the machine tool bull market, issuing a secondary for around $25 a share. The secondary had strengthened the balance sheet. Several years later, the stock had broken following the financial crisis of 2008/2009 and was trading at around $4 a share. Although the company was showing losses in accrual earnings, they were generating excellent free cash flow, had paid down almost all their debt and were reducing inventory. Looking at the balance sheet over the past five years tells the story: The company had used the temporarily favorable business period during 2007 to issue shares at around $25. At that point the stock was not only severely diluted but also significantly overvalued, trading at a sizable premium to its tangible book value. http://moneycentral.msn.com/investor/invsub/results/statemnt.aspx?lstStatement=Balance&symbol=US%3aHDNG&stmtView=Ann







Remember the quote at the top of the page by Graham that applied in spades for the investors in the Hardinge secondary offering in 2007. However, it set up an outstanding buying opportunity that would present itself two years later. By the Summer of 2009, the market cap of Hardinge was now significantly less than the money which was raised in the offering two years prior. THE BROKEN SECONDARY OFFERING coupled with the FINANCIAL CRISIS had supplied the necessary conditions for this extreme value proposition to unfold. The company was now trading at about .5x its net current assets and less than .3x its tangible equity with virtually no debt. That represented an extremely substantial margin of safety by almost any standard. In early 2010, the undervalued nature of Hardinge was recognized by Romi, who launched a take over bid at $8 per share. The bid was later raised to $10, but the Hardinge management was successful in fighting off the hostile offer.







When an extreme margin of safety presents itself I am willing to invest up to 20% of my portfolio in any one stock. That was the case with Hardinge. I have sold over half my position in Hardinge, as the price has appreciated, although it still remains one of my largest holdings. I intend to sell my remaining shares gradually as the margin of safety has disappeared, although the company has once again turned profitable and is now generating interest with investors who focus on earnings rather than assets.



Disclosure long HDNG



My next article on the tenets of value investing will discuss management effectiveness.

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