Investing Basics: What does Margin of Safety mean?

Friday, Jan 27 2012 by
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Investing Basics What does Margin of Safety mean

“To have a true investment, there must be a true margin of safety. And a true margin of safety is one that can be demonstrated by figures, by persuasive reasoning, and by reference to a body of actual experience.” 

When celebrated value investor Benjamin Graham set out his thinking on why and when to purchase stocks in his influential 1934 book Security Analysis, his insistence on having a Margin of Safety was a key factor. Years later, Graham’s student Warren Buffett described the phrase as the "three most important words in investing". But what does it mean and, more importantly, how do you make sure you have got one?

What is a Margin of Safety?

Margin of Safety is a term that is more or less owned by value investors, whose central aim is to buy stocks that they believe are undervalued by the market. Value investors apply relentless scrutiny to stocks in an effort to stand apart from the crowd and they do it by figuring out what they believe to be a company’s intrinsic, or “true”, value and then comparing that to what the rest of the market believes (read more about how investors value stocks).

The difference between the market price and the intrinsic value is the Margin of Safety. If the shares of a company currently trade for 75p, but the intrinsic value of the shares is £1.00, then the Margin of Safety would be 25%. Given that the investor is using his own judgement, the technique introduces a cushion against capital loss caused by an error of judgement or unpredictable market movements (i.e. the value of the stock falls further). Buffett described the margin of safety concept in terms of tolerances:

“When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And that same principle works in investing.”

Opinions are divided on how large the discount needs to be to qualify the stock as a potential “buy”. Indeed, the bad news is that no-one really agrees on this – for two reasons. First, determining a company’s intrinsic value is highly subjective. The way that Benjamin Graham calculated margin of safety years back was highly asset/NCAV-based, and probably quite different from how analysts/investors might today  make the calculation. Second, investors are prepared to wear different levels of risk on a stock by stock basis, depending on how familiar they are with the stock, its story and its management. 

In his writings, Ben Graham noted that:

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"the margin of safety is always dependent on the price paid. For any security, it will be large at one price, small at some higher price, nonexistent at some still higher price".

He suggested looking for a Margin of Safety in some circumstances of up to 50% but more typically he would look for 33%. 

So how can we ensure a Margin of Safety?

In his hugely popular book Margin of Safety, Risk Averse Investing Strategies for the Thoughtful Investor (now out of print and occasionally selling for $000s on Ebay – although also circulating on the Internet), Seth Klarman, the founder and president of US investment firm Baupost Group, explains how investors can try to achieve a margin of safety in their investing. His suggestions include:

  • Buy at a significant discount to underlying business value and giving preference to tangible assets over intangibles (although there are investment opportunities in businesses with valuable intangible assets)
  • Replace current holdings as better bargains come along
  • Sell when the market price of any stock matches its underlying value
  • Don’t be afraid to hold cash until other attractive investments come along
  • Pay attention to why current holdings are undervalued and sell stock when those reasons no longer apply
  • In an inflationary environment, where assets are rising in value (including “hidden assets” like pension funds and property), investors should be wary of relaxing their standards by paying too much for them, because…
  • …in a deflationary environment, hidden assets can become hidden liabilities as they lose value – “the possibility of sustained decreases in business value is a dagger at the heart of value investing”.
  • Give preference to companies having good management with a stake in the business
  • Diversify holdings and hedge when it is financially attractive to do so

As part of Stockopedia Premium, we provide a range of pre-configured valuation models to allow you to easily run your own margin of safety calculations based on current stock prices. Of course, the pre-defined values for each stock are simply a starting point based on global assumptions that we have applied across the market - you should amend them as you see fit depending on the specific circumstances of a given stock.

Caveats on Margin of Safety

Although the Margin of Safety is an embedded part of the value investing mindset, it is worth noting that academics and analysts remain divided on precisely how it can and should be used, particularly as a measure of risk. In a 2001 paper by Credit Suisse First Boston, Mauboussin and Schay looked at whether investment risk was better managed by analysing beta (how much a stock bounces around versus “the market”) or by using a Margin of Safety. They concluded that beta was a reasonable measure of risk for the short-term (up to four years) while long-term investors were better off using Margin of Safety.

However, in his Musings on Markets blog, Professor Aswath Damodaran of Stern School of Business argues that the two approaches play very different roles in investing. He believes that Margin of Safety isn’t really a risk indicator in the way that beta is. When using it, he cautions that investors should consider the following:

  • Investors should avoid distraction by looking for a Margin of Safety AFTER screening for good companies and estimated intrinsic value
  • The Margin of Safety is not a substitute for risk assessment because if an investor gets the intrinsic valuation wrong, the safety cushion could be rendered useless
  • The Margin of Safety should not be a fixed percentage but should instead vary in relation to the investor’s certainty (or otherwise) about intrinsic value
  • Introducing a Margin of Safety might reduce the chances of buying overvalued stocks but it may also make the selection criteria so conservative that there may end up being no, or very few stocks to choose from.

Further Reading:

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As per our Terms of Use, Stockopedia is a financial news & data site, discussion forum and content aggregator. Our site should be used for educational & informational purposes only. We do not provide investment advice, recommendations or views as to whether an investment or strategy is suited to the investment needs of a specific individual. You should make your own decisions and seek independent professional advice before doing so. Remember: Shares can go down as well as up. Past performance is not a guide to future performance & investors may not get back the amount invested.


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3 Comments on this Article show/hide all

UK Value Investor 28th Jan '12 1 of 3
2

For me the Margin of Safety is a direct consequence of my favourite three words in investing:

I DON'T KNOW!!!

That is the basic premise that I build any investment case on and many aspects of Margin of Safety flow directly from now knowing:

I don't know what the economy is going to do - so buy businesses that are likely to survive recessions and prosper afterwards (low debt, consumer non-durables, etc etc).  Also prefer international businesses because the economic future of any one geographic area is also highly uncertain.

I don't know which industries are going to do well - so diversify across many industries.

I don't know what any one company is going to do - so diversify across 20 or 30 or more different ones.

I don't know whcih companies are going to survive in any given industry - so prefer those that are already in industry leading positions, those that are in the "big 5" or whatever.

I don't know what inflation's going to do - so try to buy stocks that have some chance of increasing prices in line with inflation.

And there are many more.

I think that the more you can understand how much you don't know, the better off you are because you look for that Margin of Safety (in all its varied forms) precisely because you realise how little you actually know. 

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Edward Croft 28th Jan '12 2 of 3
3

In reply to UK Value Investor, post #1

I don't know if I don't know is a good investment philosophy!  One of my favourite Buffett quotes is...

"I put a heavy weight on certainty. If you do that then the whole idea of a risk factor doesn't make any sense to me.  You don't invest where you take a significant risk... its not risky to buy securities at a fraction of what they're worth."

I think the problem is that this whole industry puts a heavy weight on doing something all the time which is never a good investment philosophy!  The truth is that the best trade is often no trade at all.  Again as the quotable one would say 'You have to wait for the fat pitch'.

For me the idea of owning 30 self-picked stocks isn't a practical one for a couple of reasons.

  •  Firstly by owning 30 stocks you are really just building an expensive index substitute with a high tracking error.   
  • Secondly, there's a massive time investment in researching and committing to those 30 stocks, which is an opportunity lost elsewhere in your life !

I think there's a more sensible solution for investors who love to pick stocks.  If you do feel you need to be invested, why not buy a tracker for the majority of your portfolio but leave a comfortable percentage to indulge in stock picking for alpha with a handful of seriously high probability bets?  

Granted -  high probability bets with a big margin of safety do not happen very often - but when they do, one should be able to act with certainty and act decisively.

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UK Value Investor 30th Jan '12 3 of 3
1

In reply to Edward Croft, post #2

Using a small part of a portfolio as 'play money' or 'alpha money' is probably a good fit for a lot of people. Obviously I'd disagree that this is more sensible than hand picking 30 high quality high value stocks, but we all have our different approaches and they can all co-exist peacefully!

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