Education: Value Investing

Printable Version

What is a "Margin of Safety"?

Safety is defined as the condition of being safe; freedom from danger, risk or injury. Homeowners install fire detectors to protect their families from fire. Life rafts are found all over luxury liners in case of an emergency. Seatbelts…where exactly am I heading with this? Safety measures can be found all around us. They should also be found in your investment portfolio.

Value Investors…I Am Your Father

"Confronted with a like challenge to distill the secret of sound investment into three words, we venture the following motto, margin of safety." Benjamin Graham

Benjamin Graham, referred to by many as the “father of value investing”, has stated that investment policy can be condensed to three simple words: margin of safety. The phrase’s utmost importance was apparent when he called it "the central concept of investment.” And when Mr. Graham spoke, people listened, including his most prized pupil—Warren Buffett.

Value investors are constantly on the hunt for stocks that they believe the market has undervalued. They look to purchase stocks that are selling at a discount to their intrinsic value. In a nutshell, the margin of safety recognizes this difference in price. When a stock’s current price is below its calculated intrinsic value, the gap constitutes a margin of safety.

Graham first presented the margin of safety concept in his 1934 book, Security Analysis. He later expanded upon the topic in his 1949 work, The Intelligent Investor.

Safety First

"(To) have a true investment, there must be a true margin of safety.” Benjamin Graham

Graham uttered the above words and they can be tied to risk management. He was only human like the rest of us. He too realized the need to have some sort of “valuation cushion.”

Most valuation techniques require a number of variables that are used as inputs for the end calculation. Small changes to any of these inputs can drastically alter the calculated value. In addition, external events that are out of our control can wreak havoc with our results. We have no way of predicting events of this nature (Nostradamus aside). For these reasons, value investors must maintain a margin of safety—a mechanism that allows for these occurrences.

If you calculated the fair value of a stock to be $20, purchasing it at $15 will give you a margin of safety in case your calculation turns out to be incorrect and the stock is truly worth $18.

Level of Safety

If you are like me, after learning about the margin of safety concept, you may be asking yourself, “How large of a margin of safety should I implement?” I wish I had a clear cut answer for you, but unfortunately I don’t. The level of safety is going to depend on a few factors including:

Market Conditions

If the bulls have been running rampant, stocks are most likely trading at or above their fair values. Those who feel more content with a larger margin of safety may have a tough time uncovering companies that meet his/her criteria. This investor would have to wait for the bears to arrive or endure a smaller margin.

Risk Tolerance

Risk tolerance is defined as an investor's ability to handle declines in the value of his/her portfolio. For those with a high level of risk tolerance (they can sleep at night without worrying about their investments), they will consider stocks trading at a smaller discount to their intrinsic value, and vice versa.

Type of Company

Companies with stable revenues and earnings track records, participating in mature industries, are usually easier to value. Thus, a smaller margin of safety can apply. For companies with erratic earnings and revenues, in highly volatile industries, a wider margin may be necessary. It is tough to pin down an accurate valuation for these types of companies.

What you need to keep in mind is that there is no scientific formula to determine your margin of safety for every stock you are currently considering. However, the level should be primarily dictated by the factors discussed above. Furthermore, when it is all said and done, margin of safety by no means will guarantee you a successful investment; however, it will provide room for miscalculations. No projection, and I don’t care who you are, about the future is foolproof. No matter how you cut it, valuing stocks with exact precision is quite the challenge.