1 Extremely Important Concept In Investing: The Margin of Safety

Singapore prides itself as a clean and green country. But that’s not just in our nation’s appearance and landscape – the “clean and green” image applies to the issue of corporate governance too.

However, a recent survey done by KPMG and Singapore Management University (SMU) showed that cases of internal fraud are actually quite common, and increasing, in corporate Singapore.

In the survey, “29% of respondents indicated at least one fraud incident had occurred in their organisation over the past two years.” This is up from 22% in 2011. Put another way, there are almost 1 in 3 companies in Singapore now which have cases of internal fraud sighted in their operations.

There’s a difference between internal fraud and fraud on a company-level. The former could be of cases such as a company’s staff colluding with suppliers. Meanwhile, the latter is for cases like Eratat Lifestyle Limited (SGX: FO8), a China-based company that fabricated its bank statements.

Although KPMG and SMU’s survey was for internal fraud, it does prove a point that fraudulent activities in the corporate world are perhaps more common than we think. This can be a problem for investors.

As investors, we rely on information provided by a company to make investment decisions. We also assume that the data provided is accurate and truthful. If we can’t be certain that the information we get from companies are fraud-free, it makes our job as investors that much harder.

Fortunately, there’s a way to deal with such uncertainty, and that is, to apply the concept of a margin of safety when we invest. The concept is summarized in a previous article of mine:

 “When it comes to investing in shares, [Benjamin] Graham believed in a systematic approach that emphasized the study of a company’s fundamentals. Through the application of Graham’s systematic approach, investors would then be able to come up with an estimated “intrinsic value” of a company.

After that however, investors shouldn’t head out to purchase shares that are selling for just a tiny bit below their estimated intrinsic value. No. To Graham, investors should only make an investment if the share was selling at a price that is a long way below its intrinsic value.”

To protect ourselves from the possibility of fraud in any company, we have to ensure that we invest with a margin of safety in mind. By so doing, even if there’s occurrence of fraud in a company we’re vested in, we might be better protected due to a lower entry price.

We have to understand that the risk of fraud is not something that affects only small and obscure companies such as those found in the much-maligned S-chips space in Singapore. Even large multinationals can be guilty.

For example, UK-based retailer Tesco was investigated for fraud last year when its management indicated that they had overstated the firm’s profits by hundreds of millions of pounds.

Foolish Summary

There are many examples throughout history of frauds happening in even the least-expected companies. Investors should not wait for regulators to save them in an event of a fraud. As the saying goes “Prevention is always better than a cure” and that is why investing with a margin of safety is so important.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Stanley Lim owns shares in Tesco PLC.