Margin of Safety, a concept put forth by Benjamin Graham, has been central to the value investing philosophy for quite a while now. So much so the great Warren Buffett (Trades, Portfolio) said margin of safety may be the most important words in investing. So what exactly does the phrase mean and how can you use the idea to your advantage as an individual investor?
Talking points
- What does margin of safety mean?
- The three most important words in investing.
- What margin of safety should you demand?
“If you were to distill the secret of sound investment into three words, we venture the motto, margin of safety.” — Benjamin Graham
What does margin of safety mean?
The quote above comes from Graham's seminal book, "The Intelligent Investor," in which he explains the concept of margin of safety in great detail (Chapter 20). The book and its contents had an extremely profound effect on Buffett, Graham's student. As Buffett states, "Chapters 8 and 20 have been the bedrock of my investing activities for more than 60 years. ... I suggest that all investors read those chapters and re-read them every time the market has been especially strong or weak.” Strong words from someone who could be the best investor of all time. So let's take a minute and dive into what Graham was writing about in Chapter 20.
Margin of safety is a term that essentially represents the difference between a stock price and its underlying intrinsic worth or value. According to Graham, the further a stock's price is below the intrinsic value, the greater the margin of safety. In other words, if you invest using a healthy margin of safety, meaning you buy stocks at lower prices than you value them, you can reduce downside risk considerably. As the quote below states, securities can decline due to a number of reasons, but by investing with a margin of safety, you'll already have built-in protection for these tough times.
“A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck or extreme volatility in a complex, unpredictable and rapidly changing world.” — Seth Klarman (Trades, Portfolio)
Let's take a look at an example. Say Widget Inc. currently sells for $80 a share and we have currently valued the company at $100 a share. At current price, this would equal a 20% margin of safety, but we're looking for at least a 25% margin of safety due to the company being younger and less established so we keep our eyes on it for now. The next month Widget Inc. misses earnings estimates by 1 cent and the price drops to $70 so we pull the trigger, buying Widget Inc. at what we have deemed a 30% discount to intrinsic value, or margin of safety. Say the stock drops to $65 but then rallies to $90 over the next year before we realize we made an error and Widget Inc. is really only worth $90 a share. By using a margin of safety (30%) when we invested and buying at $70 instead of $80, the decline wasn't near as rough and the return was much better, despite the initial error in valuation.
The three most important words in investing
“The three most important words in investing … Margin of Safety.” — Warren Buffett (Trades, Portfolio)
The quote above represents Buffett's feeling on this concept. Several others, including Seth Klarman (Trades, Portfolio), who wrote an entire book on the subject, "Margin of Safety,"have also strictly adhered to the principle of buying securities at prices below their intrinsic values  – and have been quite successful doing it. All in all, however, it's easier said than done. So let's examine two crucial aspects regarding margin of safety a little closer: Valuation and Quality.
Valuation – Valuations can be awfully subjective and decently tricky. Since every investor has different methods to calculate intrinsic value, I recommend being conservative with whichever fundamental you're using, whether it be growth rate, cash flow or earnings. Understand that valuation is the single most important factor when it comes to margin of safety so being conservative and utilizing several different valuation models can provide necessary protection from the inherent assumptions that have to be made. Buying stocks below intrinsic value also serves as a great catalyst – when the market realizes the error in mispricing, the realization in underlying value can prove quite rapid – further increasing your margin of safety.
“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” — Warren Buffett (Trades, Portfolio)
Quality – The specific definition of margin of safety is buying stocks below their intrinsic values. And many investors have been highly successful implementing this concept. But for the individual investor I would like to expand the definition to buying great companies at prices below their intrinsic values. When you add in high-quality companies with a great value, you cushion your margin of safety even more. Whatever the condition may be that causes hardship for the stock, a company with a sustainable competitive advantage, great management and sufficient cash flows offers built-in protection for the individual investor. This is where I side more with Peter Lynch and Charlie Munger (Trades, Portfolio) when talking about margin of safety. It was actually Munger who convinced Buffett to alter his investment philosophy of buying "cigar-butt" stocks to invest in high-quality companies at fair prices.
What margin of safety should you demand?
So how wide should your margin of safety be? Well it depends. How accurate do you think your intrinsic value estimate is? Estimating an intrinsic value is never easy as many assumptions have to be made, depending on the type of business, whether it's stable or more volatile, small errors can result in big discrepancies. This is why I recommend calculating a fair value range you think the company is worth and using a minimum of 25% as a margin of safety. As Buffett said, it's better to have an idea of value than to speculate.
“It is better to be approximately right than precisely wrong.” — Warren Buffett (Trades, Portfolio)
Let's take a look at two examples. Say we're looking at Apple (AAPL, Financial), which currently trades for around $92, but we have estimated its intrinsic worth to be between $120 and $130. Since Apple is a stable, rock-solid, cash-generating behemoth, we can conclude it's a fairly safe investment. However, due to the law of large numbers and potentially limited growth opportunities, we still need to use a healthy margin of safety. I usually prefer a margin of safety of 25% to 33%, depending on the company. If we use this range for Apple, our buying price would be between $80 and $90 ($120 * 0.67/0.75). Since it is currently selling for $92 a share, my interest would be piqued.
Now let's look at a company that is much more cyclical and potentially more volatile, Micron (MU, Financial). Micron trades around $11, and we've estimated a fair value range between $14 and $16. This is a fairly conservative range due to current headwinds with the PC market. But we also know the upside is quite strong with the newer technology it's producing. That said, since the quality of the company is, in my opinion, lower than Apple's, this time we'll use a 33% to 50% MOS. This gives us a potential buying range of anywhere between $5.50 and $9.38 ($14 * 0.50/0.67). While these ranges may seem low, a significant margin of safety protects the investor from future, sometimes unpredictable, hardships.
Summary
- Margin of safety is a term used by Benjamin Graham in his seminal book, "The Intelligent Investor."
- Simply put, it is the difference between stock price and intrinsic value.
- Warren Buffett (Trades, Portfolio) claims margin of safety are the three most important words in investing.
- And for good reason, as it can protect investors from future uncertainty and market downturns.
- I recommend utilizing a margin of safety of at least 25% for your investments.
