“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…