Friday, April 04, 2008

Civil engineering vs value investing

Oh my, how time flies...Friday already and another week gone by. As KK would have said, only left XXXX weeks more to go :)

I realised I didn't blog much this week, so since I have both the energy and the time to do it now, I shall try to post some thoughts that are in my mind. It's about margin of safety.

I did civil engineering before, so the concept of margin of safety isn't new to me, except that it wasn't known in the engineering jargon as margin of safety - it's called factor of safety. Different words, same meaning. Thus, you can imagine that my eyes lit up when I first read Benjamin's Graham classic book - The Intelligent Investor. The concept of having a safety margin is EXACTLY the same as designing something bigger - a bridge or a building or what other things that civil engineers do.

I'll illustrate with examples..

For stocks,

1. We analyse the business and see if it's worth taking a closer look. Hence there is a screening procedure, otherwise all the stocks in the world will require 10 lifetimes or more to scrutinize closely - not possible.

2. Having ensuring a business is worth re-looking, we analyse the 3 financial statements to check that it's worth taking a shot. Step 1 and step 2 are closely related, since the screening procedure also involves numbers and ratios taken from the financial statements.

3. Calculate the intrinsic value or fair value of the business. Many methods to calculate - P/B, P/E, DCF, DFCF, DDM and other 3 letter words

4. Apply a margin of safety. This is not a fix margin for all the stocks, but rather it depends on how sure you are of the value you used for estimating the fair value. In essence, the more unsure of the input (hence the business), the higher should be the margin of safety.

5. Go buy it

That's investing with a margin of safety for you. I find that this approach parallels the design procedure in civil engineering works. Alright, granted that I lost 99% of my civil engineering knowledge. In fact, I only remember 1% of all that is taught, which is the concept of the factor of safety. Interestingly, I asked myself immediately after I graduate what I learnt from the extremely value packed (read: packed to the brim with courses and lab work spreading over 6 workdays per week) 4 year course.

What I learnt is this: Always apply a factor of safety. But if you apply too much, you'll pay too much for construction built to stand an extremely harsh condition that has a very low probability of happening. Apply too low, you'll pay less for the construction of a structure which cannot take unexpected conditions.

So how does a civil engineer design their works?

1. Do a survey of the land based on the map. Do a site visit to find out unanticipated conditions before designing. Do soil testing with a few drill holes. A 'few' meaning enough to find out reasonably what the soil conditions are yet not be overburdened with cost. Most of the time, civil engineers do not have the luxury to choose the site and deem that a particular site is not worthy of construction. Engineers will have to make it work, given any site.

2. Look at the survey results and the soil testing results. Get the working parameters of the site to facilitate design. Forecast the load that the structure is going to take given reasonable conditions. For example, to build a bridge, the average weight of a normal car is taken. A forecast of the traffic condition is made for both directions and then we'll get the load. Have to look up a engineering code book to multiply the first factor of safety to get the design load. This is because what is forecasted might not be correct, so we have to multiply the forecasted load with a safety factor to get a higher design load, in case the calculation is wrong.

3. Design the structure based on the design load. When designing the load that each beam and column have to take, we apply another factor of safety to account for a myriad of conditions like earthquakes, wind, soil settlement. In other words, the structure can take unexpected load conditions which is not forecasted, but up to a certain degree only.

4. The key is that if the factor of safety is too high, the cost of construction will be too much because we are over designing the structure for a load which is probabilistically low. Yet if the factor of safety is too low, we are stressing the structure too much and it won't be able to take in unexpected load conditions. Very dangerous as it can lead to catastrophic failure and lead to loss of lives.

You go figure what's so similar about this two disciplines :)


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