Benjamin Graham understood that an asset or business worth $1 today could be worth 75 cents or $1.25 in the near future. He also understood that he might even be wrong about today's value. Graham was not interested in paying $1 for $1 of value. Graham was only interested in buying at a substantial discount from underlying value. By investing at a discount, he knew that he was unlikely to experience losses. The discount provided a margin of safety.
Investing is deemed a science; thus, investors need a margin of safety. A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for error, bad luck, or extreme volatility in a complex, unpredictable, and rapidly changing world.
Graham explains that "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 price."
Buffett describes the margin of safety concept in terms of tolerance: "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?”
What margin of safety is good for an investor? It depends on the investor. It depends on the volatility the investor is prepared to bare, the bad lack he wants to tolerate, among other issues. In a word, it refers to how much they are prepared to lose.
Investors who take stocks as pieces of paper and are permanently investing, at all times, do not achieve a margin of safety. The same happens with greedy individual investors who prefer to follow market trends.
The only margin investors who purchase Wall Street underwritings or financial-market innovations usually experience is a margin of peril.
Anyway, among value investors, there are still discrepancies in terms of margin of safety. There are those like Buffett who have recognized the value of intangible assets without any investment being required to maintain them. The problem with intangible assets is that they hold little or no margin of safety.
On the other hand, tangible assets are more precisely valued and therefore provide investors with greater protection from loss. They do provide a margin of safety.
How can investors be certain of achieving a margin of safety? There are three elements:
· By always buying at a significant discount to underlying business value and giving preference to tangible assets over intangibles.
· By replacing current holdings as better bargains come along.
· By selling when the market price of any investment comes to reflect its underlying value and by holding cash, if necessary, until other attractive investments become available.
But investors do not only have to care about whether but also why current holdings are below value. It is paramount to know why an investment has been made and sell when it becomes necessary not to longer hold the security.
Preference has to be given to companies that are correctly managed and have a personal financial interest in the business. Another issue to bear in mind is diversification. It is important that investors diversify their holdings and hedge when it is financially attractive to do so.
Perhaps the best recent example of investing with a margin of safety occurred in the debt securities of Texaco, Inc. In 1987 Texaco filed for bankruptcy as a result of uncertainty surrounding a $10 billion legal verdict against it in favour of Pennzoil.
Although the value of Texaco's assets appeared to more than fully cover all of its liabilities even under a worst-case scenario, in the immediate aftermath of Texaco's Chapter 11 filing its stock and bonds plunged in price. As with any bankruptcy, many investors were suddenly constrained from owning Texaco securities.
Uncertainty regarding the timing and exact resolution of the bankruptcy created an outstanding opportunity for value investors who were content with doing well under any scenario while always having a considerable margin of safety.
Investing is deemed a science; thus, investors need a margin of safety. A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for error, bad luck, or extreme volatility in a complex, unpredictable, and rapidly changing world.
Graham explains that "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 price."
Buffett describes the margin of safety concept in terms of tolerance: "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?”
What margin of safety is good for an investor? It depends on the investor. It depends on the volatility the investor is prepared to bare, the bad lack he wants to tolerate, among other issues. In a word, it refers to how much they are prepared to lose.
Investors who take stocks as pieces of paper and are permanently investing, at all times, do not achieve a margin of safety. The same happens with greedy individual investors who prefer to follow market trends.
The only margin investors who purchase Wall Street underwritings or financial-market innovations usually experience is a margin of peril.
Anyway, among value investors, there are still discrepancies in terms of margin of safety. There are those like Buffett who have recognized the value of intangible assets without any investment being required to maintain them. The problem with intangible assets is that they hold little or no margin of safety.
On the other hand, tangible assets are more precisely valued and therefore provide investors with greater protection from loss. They do provide a margin of safety.
How can investors be certain of achieving a margin of safety? There are three elements:
· By always buying at a significant discount to underlying business value and giving preference to tangible assets over intangibles.
· By replacing current holdings as better bargains come along.
· By selling when the market price of any investment comes to reflect its underlying value and by holding cash, if necessary, until other attractive investments become available.
But investors do not only have to care about whether but also why current holdings are below value. It is paramount to know why an investment has been made and sell when it becomes necessary not to longer hold the security.
Preference has to be given to companies that are correctly managed and have a personal financial interest in the business. Another issue to bear in mind is diversification. It is important that investors diversify their holdings and hedge when it is financially attractive to do so.
Perhaps the best recent example of investing with a margin of safety occurred in the debt securities of Texaco, Inc. In 1987 Texaco filed for bankruptcy as a result of uncertainty surrounding a $10 billion legal verdict against it in favour of Pennzoil.
Although the value of Texaco's assets appeared to more than fully cover all of its liabilities even under a worst-case scenario, in the immediate aftermath of Texaco's Chapter 11 filing its stock and bonds plunged in price. As with any bankruptcy, many investors were suddenly constrained from owning Texaco securities.
Uncertainty regarding the timing and exact resolution of the bankruptcy created an outstanding opportunity for value investors who were content with doing well under any scenario while always having a considerable margin of safety.
