Stock Shastra #12: Buy at 50% discount to minimize risk and get fantastic returns

In Stock Shastra #11, we told you about the right value of a stock – its MRP. Having already said that you need to buy at a discount to its MRP, you must be now wondering what is this discount %, that will minimize your risk as well as give you great returns? Answering this question, will complete your quest for a great investment.

So, at what level lower than MRP should you buy the stock?

Every smart shopper prefers buying stuff on discount and you can do the same, while shopping for stocks. While calculating MRP, we considered a 15% expected rate of return. But, this is the minimum you should expect. Also, just operating on MRP, may not be the best way to invest as you are not covering any risk. So, while investing in stocks, always demand a margin of safety.

What is this Margin of safety you ask? Margin of Safety is the difference between the current price and the MRP of the stock. So, if the MRP of a stock is Rs.100 and is currently trading at Rs.70, you have a margin of safety of 30%. But is this good enough? When you invest in stocks, you should be looking for a margin of safety of 50%. You have to make sure you’re getting a rupee of value for only 50 paisa. The Value Investing Guru – Benjamin Graham insisted on a 50% MOS and we follow his guidelines while deciding on when to buy a stock.

So, for a stock with a MRP of Rs. 100, you need to wait till it gives you a margin of safety of 50% i.e it trades at Rs. 50/- This is what, we at Moneyworks4me.com, call ‘Discount Price’ – a benchmark for the Buy Price.

Discount Price = MRP *(1- margin of safety/100)

So, why look for a margin of safety?

You must be wondering why do you need to wait for a margin of safety. A couple of reasons for this are:
•    Minimize risk: Compared to other traditional investment options like bank FDs, bonds, etc stock investing comes with an additional risk. This is because of the irrational behavior of the market which drives the short-term fluctuations in the price of a share. The market almost doesn’t need a reason to react and fluctuates due to news, sentiments, baseless rumors and just about everything else.
Also, since a stock’s MRP is primarily dependant on the expected EPS growth rate in the future and the analysis may not be on the dot, you must make sure you protect yourself from this risk, too.

•    Great Returns: The other advantage by buying low is that you increase your returns. The lower you buy the stock, the higher return you get on the investment.

So, does the market give you such opportunities that you can buy the stock at a very low price? Yes, it does! In reality, there are many times, the market tends to over-react and undervalues a fundamentally strong company, probably because it is facing tough times right now or maybe due to some negative rumor, news etc. But in the long-term, its stock price will appreciate rationally based on its earning capacity. So, while investing always keep a long-term perspective in mind and make sure you take advantage of such opportunities.

Hence, to protect yourself from risk and get great returns, buy your stock at/below Discount Price i.e. at a 50% discount to MRP

Yet wondering, why such a high margin of safety of 50%? The main reason is to cover deep recession. By demanding such a high margin of safety, you are protecting yourself from all kinds of crisis. Consider this: You may buy a fundamentally strong company close to its MRP, assuming that it will appreciate. Though you are right by assuming so, soon if the economy slumps, so will its stock price; however strong the company maybe.

Though the best way to invest in stocks is to buy at a MOS of 50%, it is always difficult to find the best companies at a hefty discount of 50%, unless there is an economic crisis or the company is facing short-term trouble. Consider this: A blue chip company has an excellent financial track record, great competitive advantages for future growth and is a company worth investing in. It is available at let’s say a discount of 30% or 40%. Will you consider buying? You probably should if you feel this discount justifies its strength to grow and the quality of your analysis.

Having understood the Margin of Safety concept, you must be eagerly wanting to know where can you find the Discount Price of your stocks. For this, visit Moneyworks4me.com, where we have given you the Discount Price of around 1000 stocks. One of our most popular features is 5 Companies Below Discount Price. Here, we give our subscribers 5 well-researched stocks at/below discount every month, which enables them to take the right buying decisions. We also have our success stories here, where many stocks given below discount price, have appreciated and given our subscribers good returns.
Parekh Aluminex a stock given in the above list in October’09. From its stock price of Rs.109, then, it appreciated to a high of Rs.343(May’10), a price close to MoneyWorks4me MRP; giving a return of 200%+.  Havells India, another company given in the same list in Oct’09 at Rs.330,  reached a high of Rs. 673.70 in April’10 giving approx 100% returns.

So, now you know when to buy a stock. To know when to sell and what considerations to keep in mind while selling, wait till the next week for Stock Shastra #13.

You should also read the following:

1. Stock Shastra Newsletter
2. Stock Shastra #1: Stock Investing is not Rocket Science!
3. Stock Shastra #13: 3 Signs that tell you “Sell your Stock”
4. How to Invest? Understanding Risk & Return
5. Stock Shastra #23: Is taking high risk a necessity for gaining higher returns??