For any sensible investor, having a healthy margin of safety is essential.
A margin of safety is the difference between what an analyst believes a security (stock) is worth, right now, versus its current market price.
There are no hard and fast rules for determining an acceptable level. However potential returns should be asymmetric. That is, there should be more upside in the current price, then downside.
In his book The Intelligent Investor, Benjamin Graham, believed a true "bargain" investment was only so if "the indicated value is at least 50% more than the [market] price."
There are many models we can use to value a security with relative confidence. However, it's important to remember the output from the models is only as good as the assumptions which we put into them.
The big four banks
Recently, I've heard many brokers and analysts put 'Buy' ratings on Australia's big four banks. Namely, Commonwealth Bank of Australia (ASX: CBA), Australian and New Zealand Banking Group (ASX: ANZ), Westpac Banking Corp (ASX: WBC) and National Australia Bank Ltd (ASX: NAB).
As noted above, the true worth of a security is largely subjective. It's one of the joys of investing. However, I feel sorry for those who subscribe to the notion that our big bank stocks could be considered 'cheap'.
If you follow Ben Graham's teachings and criteria for stock selection (his disciples went on to become some of the greatest investors the world has seen, Warren Buffett and Walter Schloss) then you'd know none of the big banks are a buy at today's prices.
If you can't estimate intrinsic values, that's fine. There's plenty of quick tricks you can use to avoid potential pitfalls to your wealth.
Banks are priced off their earnings potential in bull markets and book value during market downturns. Given our goal is to make a profit from investing in the share market, it follows to price a bank from its book value (i.e. its net assets minus intangibles), rather than its earnings (think, P/E ratio).
A rule of thumb is to buy bank stocks at less than book value. That is, when the market price is less than its assets. To put that in perspective, in the fallout of the GFC, only ANZ traded below book value though NAB (which is the biggest bank by total assets) went very close. These types of situations do not occur very often in Australia at least.
Given the dominant market shares, growth outlook, competitive advantages and relative safety of Australia's two biggest banks by market capitalisation, Westpac and CommBank, my rough rule of thumb is to purchase them at no more than then 1.5x and 1.4x book value, respectively. That'd put a bargain price for their shares around $46 and $22, respectively.
Some investors will think I'm crazy for setting my price so low but it's important to note, Westpac traded in my acceptable range in 2008, 2009, 2011 and 2012 (not too long ago) whilst CBA traded below 1.5x book value in 2008 and 2009.
No stock is a buy at any price
In raging bull markets, value investors may miss out on the spectacular gains from growth stocks. But over the long haul, I believe it's the only proven strategy for continually and convincingly beating the market.
I may have missed the strong run of the big banks over the past 12 months (I sold my last big bank stock in August last year) but that's OK. Because I know that now is not the time to buy big bank shares, as the upside does not significantly outweigh the downside risk.
