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 quot;three most important words in investingquot;. 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:
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.
“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.”
In his writings, Ben Graham noted that:
He suggested looking for a Margin of Safety in some circumstances of up to 50% but more typically he would look for 33%.
quot;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 pricequot;.
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
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.