There are many ways to define a "margin of safety." Some investors look at price and compare it to assets. Other investors compare price to revenue. Many compare price to future earnings projections. Because equity investing is inherently dangerous, the important thing is to find some sort of margin of safety.
We must put the odds in our favor by identifying a price where those items are on sale. The more margins of safety we can identify, the better odds we have of a successful investment. That is, only if we have the patience to buy near those levels.
To understand the margin of safety concept better, let us examine United States Steel Corporation, a 1-Star Predictability Ranked "integrated steel producer of flat-rolled and tubular products" that traces its roots to Andrew Carnegie.
The enterprising investor must identify those margins that have historically been indicative of value. For US Steel, one of those "indicators" that has proven valuable historically is inventory. The chart below depicts the value of inventory US Steel owns. As the company has grown, the price of that inventory has risen. This can be due to both increasing physical levels of inventory as well as commodity price changes.
An astute investor would then plot the price the market has charged for that inventory. Below is a chart of that price, or market capitalization, and inventory. Notice the price in green near the level of inventory in 2003, 2009 and 2013. Knowing how much inventory US Steel owns is important. This inventory is of real value to the world. A specific dollar value is attributed to it. This is one number the enterprising value investor must use to identify a margin of safety.
When we buy milk at the grocery store, this is how we determine if price is cheap. We look at the milk, identify it is one gallon, verify it is skim or 2% and then compare it to price we paid in the past. Looking at the historical track record of some of the greatest investors in the world, like Seth Klarman, this "margin of safety" idea must be important.
An Interview with Seth Klarman and Charlie Rose from Facing History and Ourselves on Vimeo.
The more we treat investing in a similar fashion to buying milk, the less esoteric investing becomes.
Learn about inventory as a margin of safety. Learn about sales as a margin of safety. Study what the margin of safety the best investors in the world used. Conduct your own studies of the margin of safety. Let the charts be your friend.
Thank you to the late Andrew Carnegie for his gift to society that has paid dividends i.e. 1,689 public libraries.
Thank you to Gurufocus.com for providing the interactive charts.
