Price investors recognize the need for a margin of safety in calculations, providing room for potential errors and uncertainties. This principle, which is key to successful price investing, is based on the idea that buying a stock at a discount price increases the probability of future profitability when it is sold. In addition, a safety margin serves as a hedge against potential losses if the stock's performance does not meet expectations.
Price investors use a similar belief. For example, if a stock is worth $160 and is bought for $69, an investor can make a profit of $91 just by waiting for the stock to rise to its true value of $100. Moreover, if the company grows and increases in value, additional profits can be made. If the stock price rises to $110, buying the stock at a reduced price will earn $44. Otherwise, if the stock was purchased at the full price of $100, the profit is only $10.
Benjamin Graham, considered the father of price investing, held the principle of buying stocks at a price equal to two-thirds or less of their intrinsic value. This margin of safety was considered necessary to achieve optimal returns while reducing investment risk.
The challenge to the efficient markets hypothesis
Price investors do not support the efficient markets hypothesis, which claims that stock prices already take into account all available information about a company and always reflect its real value. Instead, price investors believe that stocks can be over- or undervalued for a variety of reasons.
A stock undervaluation can occur during economic downturns when investors start to panic and sell stocks en masse (as they did during the Great Recession). On the other hand, stocks can be overvalued because of excessive excitement about unproven new technologies (as was the case during the Internet company bubble). Psychological biases can affect the stock price in response to the news, such as disappointing or unexpected earnings reports, product recalls, or lawsuits. Stocks can also be undervalued because little is known about them and they are underreported by analysts and the media.
Price investors have the traits of a Contrarian - they don't follow the crowd. Such people reject the efficient markets hypothesis and often take a different approach than many other investors. When others buy, they often sell or stay away. Sellers buy or hold their positions. Price investors don't buy trendy stocks (because they tend to be overpriced). Instead, they invest in companies that are not widely known but have strong financials. They also review well-known stocks when their prices decline sharply, believing that such companies can recover from failures if their fundamentals remain strong and their products and services are of high quality.