1. How to use GuruFocus - Tutorials
  2. What Is in the GuruFocus Premium Membership?
  3. A DIY Guide on How to Invest Using Guru Strategies
Grahamites
Grahamites
Articles (398) 

Qualitative Factors Affecting Margin of Safety

6 qualitative factors to consider when assessing margin of safety

October 28, 2020

During his lecture last week, Chang Jing discussed in-depth about margin of safety, which is the most important concept in value investing. It was Benjamin Graham's core idea when he invented value investing.

Margin of safety is not a new idea. It's prevalent in daily life, but Graham was the first to formally incorporate it into investing.

According to Chang, margin of safety is the discount between the purchase price and the intrinsic value of the equity of the business. It provides a safety cushion against the uncertainty of the intrinsic value, providing a structural protection for the invested capital in case of significant adversarial events.

I thought the most important part of Chang's lecture was the qualitative way of how to view margin of safety, which I outline via the six points below.

1. Price gap between intrinsic value and market value

This is the most commonly used definition of margin of safety and is fairly straightforward. Market value fluctuates every day and doesn't require any estimate. Intrinsic value doesn't fluctuate much but it does require a certain amount of estimates.

2. Quality of assets and conservativeness of balance sheet

This is another layer of margin of safety. We know that balance sheet items are more reliable than future predictions of the business fundamentals, in most cases, and leverage magnifies both returns and risks. Therefore, the higher quality the assets and the more conservative the balance sheet is, the more reliable the margin of safety is.

3. Quality of earnings and moat

Earnings power is the second source of intrinsic value. A wide-moat business which can sustain its moat can sustain its earnings power. If earnings can convert to free cash flow,and if we assume the business doesn't do stupid things with the excess cash flow, assets will grow over time. With growth of assets comes with a larger margin of safety over time.

4. Growth

Profitable growth is the least reliable source of intrinsic value but can also be the most significant component of intrinsic value. If the business can sustainably grow its earnings over time, it can grow its intrinsic value as well. Therefore, after the purchase of the business, if the price doesn't move, the margin of safety is getting larger and larger. Even if the price appreciates, if it does so at a slower speed than the growth of the intrinsic value, the margin of safety will still get larger over time.

5. Management quality and culture

This is a purely qualitative factor. Quality of assets, conservativeness of balance sheet, quality of earnings and growth opportunities are all accumulated results of the industry characteristics, management decisions and the culture of the business. A high quality management team and a superior organization culture can give us more convictions about the sustainability of quality of assets, conservativeness of balance sheet, quality of earnings and growth opportunities, which are all important sources of intrinsic value.

6. Circle of competency

Circle of competency is also an important dimension of margin of safety. It is closely related to intrinsic value and margin of safety. For example, to assess quality of assets, an investor needs to have some competency in accounting. To assess the quality of earnings and moat, to predict the future growth prospect of the business and to assess the risk events and likelihood of the risk events, an investor needs to build some competency in the business and the industry first.

I think there's one more layer here. As human beings, we naturally tend to overestimate our ability to understand something, so we should factor that in when thinking about circle of competency. In other words, we should build a layer of margin of safety on top of our circle of competency. One way to achieve this goal is to apply a discount to our own estimates of our level of understanding of a business.

Conclusion

Margin of safety, to some extent, is a very personal concept. It is also a simple yet profound concept. In practice, there are many quantitative and qualitative factors to consider. This multi-dimensional nature of margin of safety often makes it the key differentiator among value investors. It is the different level of understanding and practice of margin of safety that separates the truly great investor from the average investor.

Read more here:

Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.

About the author:

Grahamites
A global value investor constantly seeking to acquire worldly wisdom. My investment philosophy has been inspired by Warren Buffett, Charlie Munger, Howard Marks, Chuck Akre, Li Lu, Zhang Lei and Peter Lynch.

Rating: 5.0/5 (6 votes)

Voters:

Comments

Please leave your comment:



Performances of the stocks mentioned by Grahamites


User Generated Screeners


pjmason14Momentum
pascal.van.garsseHigh FCF-M2
kosalmmuse6
kosalmmuseBest one1
DBrizanall 2019Feb26
kosalmmuseBest one
DBrizanall 2019Feb25
kosalmmuseNice
kosalmmusehan
MsDale*52-Week Low
Get WordPress Plugins for easy affiliate links on Stock Tickers and Guru Names | Earn affiliate commissions by embedding GuruFocus Charts
GuruFocus Affiliate Program: Earn up to $400 per referral. ( Learn More)