Empire Investing Strategy Review - Part 2

In the first part of this review, I looked at the first two components of the investing strategy outlined at the Empire Investing website.  These were the 1. Filter and 2. Value steps.  I'd now like to take a look at the next few:

• 3. Assign Risk - utilise a margin of safety.
• 4. Observe - Concentrate and watch the select few closely - like a hawk.
• 5. Act on Buy Signals - Purchase on every buy signal.

I've leave "6. Assign Capital" for another post, as I think that that is complex enough to warrant it's own post.

Assign Risk - ustilise a margin of safefy

I've never quite got the concept of "margin of safety".  I understand that estimations and predictions have a margin of error, and that by creating a margin of safety, one hopes to eliminate, or at least minimize, the risk of a negative outcome.  However, what I can't grasp is how this is any different to the concept of maximizing expectation value, or in layman's terms "trying to make as much money as possible", and hence why it's referred to as "margin of safety" rather than "maximizing profits".


For example, consider purchasing a company that you value at $100,000.  The margin-of-safety principal says that you should set your buy-price at $80,000, to give yourself a margin of safety of 20%.  That is, in the event that your valuation is incorrect, you should leave yourself buffer, to ensure that you make money even your you're a little wrong.

However, the margin-of-safety principle says that at $60,000, you have an even bigger margin of safety, and at $40,000, you have an ever bigger margin-of-safety yet again.  But why are we talking about margins-of-safety instead of rates-of-return? 

Anyway, in the context of Empire, I understand that they might have some understanding of the unknowns and risks, and fudge (for want of a better term) those into their valuations.

Observe - Concentrate and watch the select few closely - like a hawk.

I think that this step is very important, and probably a little understated as written.

Firstly, the term "concentrate" could refer to either the reverse-diversification aspect or the focus aspect.  By concentrating your portfolio on a small number of quality stocks, rather than diversifying across a large number of stocks, you are increasing returns and increasing price volatility, and for the highly disciplined and diligent investor, this makes sense.

I suspect, however, that "concentrate" refers to keeping an eye on each of companies under review - particularly as they approach the buy-signal price.  The reason for this should be obvious.  As a company is approaching is buy-price, it's price must necessarily be declining.  So, why is "the market" valuation of this company in decline?  Is the the price of the company in decline, or is the value of the company in decline?  Have any of the fundamentals of the company changed that should cause my valuation of this company to change?

This is probably the critical time for a value investor.  He needs to re-assess his valuation, in the face of all the negativity from the market and either a) admit that he was wrong in his initial valuation, and down-grade his valuation of the company, or b) be correct is his assessment AND be confident enough to believe that he is right and the market is wrong.

Act on Buy Signals - Purchase on every buy signal.

Hopefully, at an investment company like Empire, this step would be automated.  All of the manual leg work should be done in the previous step, and therefore this step should literally be clicking the button, or the auto-pilot system informing you that the "buy" button was clicked..

Similarly, in my own "investment system", I hope to get to the stage where this step is automated.

The next step is the one that I really haven't figured out yet - which is the "allocation" step.  That is, how many shares should I buy?  My head hurts.  I think I'll go and procrastinate..