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Dealing with the Margin of Danger (Part II)
How can investors deal with the margin of danger?
The important thing for investors to accept is that the margin of danger comes hand in hand with the margin of safety. This means that we can never completely remove the margin of danger, but can only minimize the probability of the intrinsic value estimate being wrong, and mitigate the impact if it is wrong. That is, we want to flatten the curve from the dotted line to the solid blue line:
The Montaka team has used the below mechanisms (among others) since inception to help us manage the margin of danger by minimizing both the probability and consequences of our intrinsic value estimates being wrong.
This exercise helps investors detach themselves from historical price movements and the price they historically paid for the shares, because the only considerations relevant to investors are the current share price and their estimate of intrinsic value based on all information they know up to that point. This also prompts investors to constantly update the margins of safety on their stocks (and thus think about the margin of danger). If the decision is not to buy back a stock in this theoretical exercise, then perhaps the perceived margin of safety is wrong and the stock should be taken out of the portfolio. (We also repeat the same exercise for our short portfolio.)
Seth Klarman summarized the duality of value investing succinctly when he said that investors need to be arrogant enough to think the market is wrong and bet against it, but also humble enough to recognize when he is wrong and the market is right. Investing on the margin of safety is the arrogance; respecting the margin of danger is the humility.
Daniel Wu is a Research Analyst with Montgomery Global Investment Management. To learn more about Montaka, please call +612 7202 0100.
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