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| Margin of Safety |
What It Is:
The term Margin of Safety has several different connotations in the
financial world. In some circles, the term refers to the difference between the
value of a debt or equity issuance and the underlying assets securing the issue.
Elsewhere, it can also mean the excess of actual sales over the revenues needed
to break even.
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However, the most well known usage occurs in security analysis, where margin of safety has come to be known as the amount by which a company's shares are trading below their intrinsic value.
Columbia professor Benjamin Graham, considered by many to be the "father of value investing," is credited with conceiving the margin of safety concept. Graham first introduced the idea in his 1934 book, Security Analysis, which he coauthored with colleague David Dodd. Graham later elaborated on the topic in his 1949 work, The Intelligent Investor. Today, such renowned investors as Warren Buffet and Bill Miller have centered their investment philosophies on the margin of safety concept.
How It Works/Example:
"Confronted with a like challenge
to distill the secret of sound investment into three words, we venture the
following motto, Margin of Safety."
-- Benjamin Graham
Margin of safety is not to be confused with standard deviation or beta, which are measures of volatility. Rather, at its core, those who practice margin-of-safety investing seek to minimize risk by focusing on stocks that trade substantially below their intrinsic value. Regardless of the product, it is always preferable to buy things at a discount to their real value. However, this is particularly true with stocks, which are extremely difficult to value with exact precision.
Suppose a consumer was in the market for a used car that was, according to the latest edition of Kelley Blue Book, valued at approximately $10,000. Armed with this knowledge, he or she could then confidently make an offer of $9,500 for the automobile with reasonable assurance that the selling price was fair.
Unfortunately, buying stocks is seldom such a cut-and-dried process. Instead, it requires quite a bit more due diligence to be successful. To begin, there is no "blue book" that investors can flip through to look up the latest fair value for a given company. Some of the most popular valuation techniques, such as discounted cash flow analysis, can indeed yield an inherent value of a stock's true worth. However, numerous variables are used as inputs for the calculation -- such as projected sales, cash flow growth, or interest rates -- and unfortunately, 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.
Thus, an investor who pays $9.50 for a stock that he/she believes is really worth $10.00 per share may or may not have actually overpaid. That depends on how accurate the $10.00 per share fair value calculation proves to be. Suppose the company was touting the launch of a hot new product line that was expected to fuel strong growth in the coming years. If a year later it turns out that the new product line failed to generate the high demand that was anticipated, then the firm's sales and cash flows will likely fall short of expectations. In this case, the original $10.00 per share intrinsic value (which was calculated based on stronger projected growth rates) may prove to be overly optimistic.
Once the investor determines the intrinsic value of a stock and can therefore calculate its margin of safety, he/she must compare this margin to a benchmark rate of return on a low-risk investment. (In most cases, U.S. Treasuries are used as a benchmark for this risk-free rate of return.) By comparing the potential return of a stock or other investment to that of a risk-free bond, the investor can get a better sense for whether the margin of safety will adequately compensate him/her for the risk involved. Because investors must continually choose whether to invest in stocks or bonds, the two asset classes are in a constant state of competition against each other to attract money.
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 their riskier stock investments. However, if risk-free rates are low, then investors might accept a lower margin of safety.
Why It Matters:
When the term "margin of safety" was introduced, it also ushered in
the notion that a stock's intrinsic value could be methodically calculated.
Graham demonstrated that this could be done by analyzing a company's assets and
business model and forecasting its future earnings. However, there are many ways
to do this, and virtually all methods of calculating intrinsic value involve
making predictions that may eventually prove to be inaccurate and/or could be
influenced by unpredictable factors down the road. Decisions based on these
methods therefore involve some degree of risk. For this reason, value-oriented
investors generally try to incorporate a margin of safety that allows for these
possibilities.
How large of a margin of safety is needed for a stock to be considered a true value investment? This depends on several factors, including market conditions, risk tolerance, and even the fundamental prospects for the company in question. When an investor feels very confident that his/her inherent value figure is accurate and unlikely to fluctuate substantially, then a thinner margin of safety might be suitable. This is usually the case with 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 other companies, particularly younger ones operating in volatile industries, can be an exceedingly difficult task. In this case, prudent investors should generally demand a higher margin of safety to compensate for the uncertainties behind the calculation.
Like most other facets of investing, there is no single correct method, and every investor must determine his/her own preferred margin of safety. Some may feel quite comfortable buying stocks that are trading at a 10% discount to their intrinsic value, while others wouldn't even consider a stock to be a good candidate unless it was selling 30% or more below its fair value.
As mentioned earlier, market conditions might also dictate or influence an investor's margin of safety requirements. For example, in an overheated bull market where valuation levels are over-extended, many companies will trade near or even above their intrinsic values. In this environment, a deep-value investor who prefers a large margin of safety of 50% or more may find few candidates that meet his/her criteria. In this case, he/she will be forced to either accept a smaller margin, or be prepared to wait for a pullback that might deepen the pool of investment ideas.
Benjamin Graham's margin of safety idea was born out of his observation that investors can never know everything about a given company. And even if all company-specific risks could be accounted for, there are still an endless number of other macroeconomic factors -- such as an economic slowdown, rising interest rates or geopolitical events -- that could trigger a sharp decline in equity prices. By narrowing down the investment universe to only those stocks that are trading far below their intrinsic value, investors can help reduce some of the risks associated with such unpredictable variables.
Perhaps Warren Buffet summed it up
best, saying "It is better to be approximately right than precisely
wrong." All investors will make flawed decisions from time to time, but the
biggest mistakes are made when investors do not prepare for them. Value
investors believe that the best way to prepare for tomorrow's uncertainties is
to only purchase investments that offer a significant margin of safety.
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