Value investing or dividend investing may often be thought of as conservative investing methods, and this may be true in many cases. But the purpose of a margin of safety is not just to protect your rate of return, but indeed to improve it.
When you buy a stock below calculated fair value, an expectation is that in some future time, the stock price will go back up to fair value in a rational market. If your growth expectations end up being correct, and you bought at an undervalued price, then you should eventually get a superior rate of return.
Alternatively, the longer the stock remains undervalued, the better it is for shareholders, because their reinvested dividends, or their new purchases, or management’s share buybacks, continue to accumulate undervalued shares. It actually becomes a demonstrably negative scenario for a long term investor when their stocks go up above fair value.
That’s how Buffett made 30-50% returns in his early days. He wasn’t investing in companies that were growing earnings by 30-50% per year; he was investing in companies that were seriously undervalued. Eventually, those stocks will return to normal values, and the longer they don’t, the better it is for the investor.
(Note: Rather than picking large caps like IBM, he was a deep value investor, finding huge mismatches between price and value. As his base of capital grew, it was no longer economical for him to invest in small companies and he either had to buy whole companies or invest primarily in large caps that either have GARP or dividend growth characteristics.)
Check the article tomorrow for an example illustration of the concept.This article was written by Dividend Monk. If you enjoyed this article, please subscribe to my feed [RSS]