Building a margin of safety

By Jim Slater (chairman of the legendary financial conglomerate, Slater Walker Securities)

1. Develop a method that suits you.

Carefully select a method of investment and then, based on personal experience and the performance of your portfolio, hone, temper and refine it until you are satisfied beyond doubt that it works for you. As you become more expert you can use several different methods at the same time according to market conditions.

2. Establish a margin of safety.

Any method, whether it be growth or value, should be based on establishing a margin of safety – a cushion between the amount you pay for a company’s shares and the amount you believe they are worth. The attraction of building a margin of safety is that it helps to protect against downside risk and at the same time provides the scope for an upwards re-rating.

3. Adjust the margin of safety to your approach.

For growth stocks, a typical method embracing a margin of safety would be to seek out shares with strong earnings growth records and a relatively low price-earnings ratio in relation to their future growth rates. Ideally the growth rate should be at least one third more than the price-earnings ratio. To increase the safety factor, it is also highly desirable for the company to have a record of strong cash flow in relation to earnings per share and a strong balance sheet.

For value stocks, the margin of safety can be established by a low price-to-sales ratio, low price-to-book value and strong cash flow. Also with many undervalued asset situations it pays to look for recent relative strength and recent directors’ buying which can be signals that a company is about to turn around.

4. Keep an eye on significant share dealings by directors.

Directors’ buying is frequently linked to a change in a company’s fortunes especially if the directors are buying a significant number of shares in a cluster of three or more. Equally, directors selling large tranches of shares is often a warning signal and should put you on red alert.

5. Judge management by their numbers, not by their manners.

The ability of management is very hard to quantify. If you go to see them or meet them at a presentation, they naturally put their best foot forward. Management can best be judged by several years of good results with brokers’ forecasts confirming that they are likely to continue. The financial results are the best judge of management, not the people going to see them.

6. Look for positive relative strength to corroborate your view of a share.

Shares that perform well in the market are often winners in the making. With growth stocks, relative strength in the previous twelve months should be positive and certainly greater than the one month figure. O’Shaugnessy found in What Works on Wall Street that relative strength was in most years the best single investment criterion.

7. Run profits and cut losses.

This is much easier said than done but it is far better practice to add to winners and pare down holdings that are not performing well. This way your losses will always be small and your gains can be gigantic. Remember that the power of compounding is the eighth wonder of the world.

8. Never stop learning.
There is always a faster gun, so keep reading books on investment by well-known and established experts, attend investment conferences and consider joining an investment club. Also make sure that you have a regular source of sound statistical stockmarket data. In the UK, Company REFS does, of course, come to mind!

9. Be tax efficient.

Use annual capital gains tax allowances, PEPs, ISAs and a personal pension scheme to the maximum possible extent.

10. Don’t kid yourself.

Do not be fooled by your own excuses. Measure your investment performance honestly and regularly and if, over a year or so, you find that you are not consistently beating the market, delegate to an expert manager or invest in a unit trust or tracker fund and use your surplus time and energy elsewhere.