How To Use “Margin Of Safety” For Buffett-Like Gains…
In the financial world, the term margin of safety can have several different connotations. But in most cases, individual investors may be familiar with this term when discussing “value investing” or security analysis.
In this context, margin of safety refers to the amount by which a company’s shares are trading below their intrinsic value.
Columbia professor Benjamin Graham is considered to be the “father of value investing”. He formulating the concept of margin of safety in his 1934 book, Security Analysis, which he co-authored with David Dodd. Graham later elaborated on the topic in his 1949 work, The Intelligent Investor.
More recently, Graham disciples such as Warren Buffet and Bill Miller, have used this concept to well-known success.
So what exactly is margin of safety – and how can investors put this idea to use themselves? Let’s dive in…
Ben Graham, the “father of value investing”.
How Margin Of Safety Works
Everyone likes to buy things at a discount. At the very least, we all want to at least make sure we’re getting a good deal.
Unfortunately, stocks can be extremely difficult to value with exact precision.
Those who practice margin-of-safety investing seek to minimize risk by focusing on stocks that trade substantially below their intrinsic value.
There are myriad ways to value a stock. And getting into the specifics of these methods is beyond the scope of this article. But what’s important to know is that some of the most popular valuation techniques, such as discounted cash flow analysis, use numerous variables as inputs for the calculation. Projected sales, cash flow growth, interest rates, the list goes on…
These figures can (and often do) deviate sharply from the numbers originally forecast. What’s more, even small changes in these underlying assumptions can result in a dramatically overstated or understated inherent value figure.
Let’s say an investor who pays $9.50 for a stock that they believe is really worth $10 per share. In reality, they may or may not have actually overpaid. That depends on how accurate the $10 per share fair value calculation proves to be. Suppose the company launched a hot new product line that could fuel strong growth in the coming years. A year later, it turns out the new product line failed to generate the high demand that was anticipated. Of course, then the firm’s sales and cash flows will likely fall short of expectations. In this case, the original $10 per share intrinsic value may prove to be overly optimistic.
In this example, the investor is paying 95% of the estimated inherent value ($9.50/$10). So he is only leaving a relatively thin margin of safety of 5%. However, let’s say the same investor refused to buy the stock unless it was trading at a 30% discount to its inherent value, or $7 per share. Then he would obviously have a much greater margin of safety. The farther a company’s shares are beneath their fair value, the larger the margin of safety. Conversely, if a stock is trading at or even above its fair value, then the margin of safety would be zero.
Once the intrinsic value of a stock and margin of safety is determined, some investors take it a step further. There’s also the matter of other investment alternatives to consider in the context of risk. You can do this by comparing margin of safety to a benchmark rate of return on a low-risk investment. (In most cases, U.S. Treasuries are used for this.)
Generally speaking, if risk-free rates (and thus, demand for fixed-income investments) are relatively high, then it stands to reason that investors might demand a larger margin of safety on riskier stock investments. However, if risk-free rates are low, then investors might accept a lower margin of safety.
Why Margin Of Safety Matters
Today, the notion of evaluating a stock’s intrinsic worth through methodical analysis seems obvious. But when “margin of safety” was introduced, this was a relatively new concept.
Graham demonstrated this by analyzing a company’s assets, business model, and forecasting its future earnings. There are many ways to do this, of course, and virtually all of them involve making assumptions that may eventually prove to be inaccurate. Plus, unexpected events are always a possibility. Because of this, savvy value-minded investors can try to incorporate an extra degree of safety to allow for at least some uncertainty.
How large of a margin of safety do you need for a stock to be considered a true value investment? It depends on several factors, including market conditions, risk tolerance, and even the fundamental prospects for the company in question.
If you feel confident that your inherent value figure is accurate and unlikely to fluctuate much, then you may prefer a thinner margin of safety. The same goes for considering well-established firms in mature industries with clear earnings visibility and stable cash flow track records. On the other hand, trying to pin an exact fair value on younger companies operating in volatile industries can be an exceedingly difficult task. In this case, you may want to demand a higher margin of safety to compensate for the uncertainties.
The point is that there is no single correct method. Every investor must determine their preferred margin of safety. (Some may be comfortable with a 10% discount, while others may want a stock selling 30% or more below its fair value.)
In an overheated bull market where valuation levels are over-extended, many companies will trade near or even above their intrinsic values. In this case, you may find few candidates that satisfy your criteria. If you’re not willing to accept a smaller margin of safety, and would prefer to wait for a pullback, that’s okay.
It’s important to remember that investors can never know everything about a company. Even if all company-specific risks could be accounted for, there are still an endless number of other macro factors… An economic slowdown, rising interest rates, or geopolitical events (like a global pandemic) could trigger a sharp decline in equity prices. But margin of safety can help investors narrow down the investment universe to find stocks that are trading for attractive valuations, reduce risk, and increase the chances of success.
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