Obtaining a margin of safety when buying shares may seem less important now than it was a year ago. Then, the economic and political outlook was extremely uncertain. Furthermore, trading conditions were very challenging for a wide range of businesses due to Covid-19 and the lockdown measures it prompted.
By contrast, the prospects for many companies, as well the economic and political outlook, may appear to be more stable today. This is reflected in the stock market’s performance over the past year. It has risen by 32% in that time, with many companies now trading on price multiples that are in excess of their long-term averages.
However, buying stocks at a discount to their intrinsic value remains of vital importance. The future may now seem more conducive to upbeat operating conditions for many sectors. But the events of the first quarter of 2020, when the stock market declined by 34% in just five weeks, show that the outlook for shares can change extremely quickly and without warning.
Klarman’s approach
Indeed, Baupost Group co-founder Seth Klarman (Trades, Portfolio) has previously highlighted his requirement for a margin of safety when purchasing stocks. As he once said:
“There are only a few things investors can do to counteract risk: diversify adequately, hedge when appropriate, and invest with a margin of safety. It is a precisely because we do not and cannot know all the risks of an investment that we strive to invest at a discount. The bargain element helps to provide a cushion for when things go wrong.”
I think Klarman’s views are extremely helpful to investors even in current market conditions. His assertion that it is impossible to fully understand all the risks when making an investment–even taking into account his strong track record and level of experience–strengthens the case for a margin of safety.
Furthermore, his belief that things will, at times, "go wrong" further emphasizes the importance of paying less for a stock than you think it is worth. Companies that are purchased with little or no margin of safety could be hit relatively hard in a market downturn.
Searching for opportunities
Of course, finding stocks that offer a margin of safety can be a tough process in today’s bull market. However, not all sectors or stocks have matched the wider market’s performance. Some companies, like those in industries that stand to benefit to a lesser extent from forecasted economic growth, may offer better value for money than cyclical stocks. Likewise, companies in industries where low interest rates are detrimental to earnings growth, such as the banking sector, may offer wider margins of safety than other industries.
As such, it may be more important than ever to cast a wider net when searching for stocks that trade at a discount to their intrinsic value. This does not mean seeking companies outside your circle of competence. Rather, it means investors may need to look beyond popular shares or companies they have previously analyzed to find stocks that offer sufficient risk-reward opportunities to merit purchase.
