The intra-day moves on the day of the election result did throw out quite a scare and many nervous moments, but in the end turned out to be a false positive. So far so good. But if not anything, events like these must make us assess whether we/our portfolio was ready to deal with long, deep corrections.

You can be sure that at some point in time a deep painful correction will play out, unless this time markets have found a way to decouple from centuries of repetitive patterns of boom and crash. You can be even more sure that you will not be able to predict the why and when of the correction.

Take these for example – at the start of January 2008, when Sensex was at 21,000, a famous brokerage house had a Sensex target of 28,000. Even after the bear market had started in 2008, the broker remained very bullish during February/March 2008. By the time reality was understood it was too late, akin to the boiling frog analogy! Most of the ‘market experts’ didn’t see the correction coming.

Or take the case of the market correction that played out starting September 2018. Back then, many were expecting markets to cool off/correct in December 18, few months before the General Elections in April/May 2019. Hence the widely advised playbook then was to take some chips off the table in December 2018, and hold positions till then.

But out of the blue came the IL&FS fiasco, triggering a deep correction months ahead. It took over two years for the bellwether index to cross the peak reached in September 2018 on a sustainable basis.

So needless to say, it’s pertinent to take stock. Also, the swift recovery from election results day lows provides an excellent opportunity to do so amid changed dynamics of a coalition government.

How to take stock? Following the simple three words – ‘margin of safety’ shows the way. In his letter to shareholders in the year 1991, Warren Buffett quotes Benjamin Graham from the book, The Intelligent Investor. “Confronted with a challenge to distil the secret of sound investment into three words, we venture the motto, ‘Margin of Safety’ .” He adds, “the failure of investors to heed this simple message caused them staggering losses’. In his view, those three words represent the cornerstone of investment success.

So,  what exactly is this margin of safety that you can apply in taking stock of your investments? You can approach in three main ways.

Value over price

The way many mid/small cap and PSU stocks corrected on the election results day is a classic example of how those stocks were priced to perfection and had no margin of safety. The sustenance of their share price was contingent upon a certain thesis playing out — i.e., continuity of a strong government at the Centre. Whether they were valued at stratospheric levels even in the case of a strong government is a factor worth considering.

More examples abound. Take the case of the Nifty IT index which is still languishing below levels reached more than two years back. India’s quality stocks consisting of a few paint and leading private sector banks too have underwhelmed in recent years.

Such underperformance has less to do with their business, but more to do with the fact that at peak levels, investors overpaid. Rather than being priced at margin of safety, they were priced at margin of danger!

So, here is rule number one with regard to margin of safety. See whether your stocks at current levels can withstand a few things going wrong — revenue or earnings slowdown, margin or earnings compression, or some regulatory action, etc. If the stock’s value appears higher than the current price, even if you account for these, then it’s well set. Else, not.

Time horizon

In stressing on value over price, Buffett often refers to intrinsic value of a company. However he also caveats this with ‘this is a number that is impossible to pinpoint.’ Despite our best efforts, we may still estimate the value of a stock wrongly. Hence it helps to build an additional layer of margin of safety by having a longer time horizon.

This is all the more true when it comes to technology and new-age companies which are more difficult to value than traditional businesses. A good example here is Amazon. Even if you had bought the stock at its peak during the dotcom boom, you would have made 36x returns in the last 24 years. So you actually valued it right at this stratospheric levels as 36x in 20 years is quite some amazing returns (although if you had bought at the bottom you would have made 366x returns).

However, this path to 36x returns was paved with a 90 per cent drawdown when the dotcom bubble burst and then recovery from 2002 to 2007 to your cost price. This was then followed by a 50 per cent drawdown again (global financial crisis), followed by over a decade-long-journey of amazing wealth creation.

So here is an example where even if you bought at peak levels, but got the business and prospects right, margins of safety in terms of time can help make up for it.

Diversification

Same example as above, but instead of buying Amazon, if you had bought a Cisco, or Intel, or Nokia, or Wipro, you would have been left with either loss of wealth or sub-par returns (albiet positive) even if you had bought these stocks 50 per cent below peak levels. This is despite the fact that their respective sectors and themes thrived over the last two decades and these companies were amongst sector leaders for long periods. Unexpected disruptions, such as commoditisation of products or entry of stronger competitor blunted their edge.

Hence, it is important that value and time horizon is complemented with diversification to make the  ‘margin of safety’ process complete.

Having a diversified portfolio will also give the comfort of ability to average when the stocks are not doing well. Say, for example, if 20 per cent of your portfolio is in one stock and it falls 50 per cent, you will need the equivalent of 10 per cent of your portfolio to double down. If only 5 per cent is in a single stock, it is easier to double down if the investing case is convincing.

Being able to double down has worked well in many bl.portfolio recommendations such as Indus Towers and Oracle Financial Services Software where, after giving accumulate rating following a margin of safety approach, we recommended that investors double down at lower levels, resulting in far superior returns over the last two years. Highly concentrated holdings is best left to few specialist fund managers to attempt.

Money can be made in the market in many ways, but following a margin of safety approach that encompasses a  mix of value-time horizon – diversification,  provides a way to make wealth while at the same time being able to sleep well at night. When implemented well, election results, geopolitics or a US recession will not bother you. As Buffett once said, he doesn’t worry the least about 2008 type crisis ‘Because I conduct myself so if there’s another crisis I’ll still be around’

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