The margin of safety is one of the most essential principles of investing. The phrase was first coined by the man who is widely considered to be the godfather of value investing, Benjamin Graham.
Graham believed that for investors to remove the uncertainties associated with investing in the stock market, they should buy a stock when it is trading at a deep discount to their estimate of intrinsic value. This would help ensure that any uncertainties were factored into the purchase price. In his works, Graham noted that no matter how much time one spent evaluating investments, it was impossible to remove all of the uncertainties.
For example, no amount of research would have established how badly the pandemic would have affected some businesses or how other companies could benefit from the stay at home necessities and the jump in demand for essential goods and services.
But the margin of safety principle does not just apply to stock prices, in my view. It applies to company fundamentals as well.
The profit margin of safety
Companies with high profit margins and strong balance sheets have their own margins of safety, which might be worth considering when one is investing in businesses.
Take Apple (AAPL, Financial), for example. This organization has reported an average operating profit margin of 26.7% since 2015. The figure has dropped a bit since 2015, falling from around 31% to 24% for 2020, but rising revenues have helped offset this impact on the bottom line. The group's gross margin was nearly 38%.
The substantial operating profits and gross margins reported give Apple a margin of safety. The group reported total gross earnings of $105 billion last year and operating expenses of just under $40 billion. On that basis, even if gross income slumped 50%, the group will still be profitable. At the same time, Apple's balance sheet has nearly $100 billion in cash.
The margin of safety here is Apple's ability to weather uncertainty and a decline in sales. Many other businesses don't have these qualities. According to my research, General Motors' (GM, Financial) gross income would only need to fall around 10% before the company started losing money.
This is only a rough estimate. Like most automakers, the company achieves strong economies of scale, which can work in reverse. As well as being beneficial for the company when unit sales are increasing, they can accelerate cash outflow when sales are declining. On top of the above, General Motors' balance sheet is highly geared and lacking cash.
I've used these two companies as an example because they have so many different qualities. Apple's business model is based around high margin technology products and subscription services, while General Motors has to work a lot harder to earn each $1 of profit. That means the automaker has less flexibility in its operations, translating into a smaller margin of safety. Apple has a much larger margin of safety by this estimate because its products are far more cash generative.
The understanding of these margins of safety on an underlying fundamental level is critical because it feeds into the overall margin of safety concept. As General Motors has a low margin of safety from an operational perspective, one may demand a wider safety margin when buying the stock. There's far more that could go wrong with the investment that would make an analysis of the firm's intrinsic value harder.
On the other hand, with Apple, I think accepting a slimmer margin may be adequate. We know the company has more stable, predictable cash flows and a larger margin for error if its operations run into headwinds.
Disclosure: The author owns no stocks mentioned.
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