37 lines
2.7 KiB
Plaintext
37 lines
2.7 KiB
Plaintext
198 • The Intelligent Option Investor
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time to take a larger position and to use more leverage is when the market is
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pricing a stock as if it were almost certain that a company will face a worst-case
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future when you consider this worst-case scenario to be relatively unlikely. In
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this illustration, if the stock price were to fall by 50 percent—to the $8 per share
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level—while my assessment of the value of the company remained unchanged
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(worst, likely, and best case of $6, $25, and $37, respectively), I would think I
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had the margin of safety necessary to commit a larger proportion of my portfo-
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lio to the investment and add more investment leverage. With the stock sitting
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at $8 per share, my risk ($8 − $6 = $2) is low and unlikely to be realized while
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my potential return is large and much closer to being assured. With the stock’s
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present price of $16 per share, my risk ($16 − $6 = $10) is large and when bad-
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case scenarios are factored in along with the worst-case scenario, more likely
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to occur.
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Thinking of margins of safety from this perspective, it is obvious that
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one should not frame them in terms of arbitrary levels (e.g., “I have a rule
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to only buy stocks that are 30% or lower than my fair value estimate. ”), but
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rather in terms informed by an intelligent valuation range. In this example,
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a 36 percent margin of safety is sufficient for me to commit a small
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proportion of my portfolio to an unlevered investment, but not to go “all
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in. ” For a concentrated, levered position in this investment, I would need a
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margin of safety approaching 76 percent (= ($25 − $6)/$25) and at least over
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60 percent (= ($25 - $10)/$25).
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When might such a large margin of safety present itself? Just when
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the market has lost all hope and is pricing in disaster for the company.
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This is where the contrarianism comes into play. The best time to make
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a levered investment in a company with high levels of operational lever -
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age is when the rest of the market is mainly concerned about the possible
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negative effects of that operational leverage. For example, during a reces-
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sion, consumer demand drops and idle time at factories increases. This
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has a quick and often very negative effect on profitability for companies
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that own the idle factories, and if conditions are bad enough or look to
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have no near-term (i.e., within about six months) resolution, the price of
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those companies’ stocks can plummet. Market prices often fall so low as to
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imply, from a valuation perspective, that the factories are likely to remain
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idled forever. In these cases, I believe that not using investment leverage in
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this case may carry with it more real risk than using investment leverage |