Margin Of Safety Investing by Investor Vantage

“If you were to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.”

– Benjamin Graham

When it comes to investing in the stock market few people can give you better advice than Warren Buffett. Back in 1971 Mr. Buffett gave a first-hand demonstration of the three key investment principles that everyone should keep in mind when making investment decisions.  We will discuss this in a minute with his purchase of Washington Post…

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He explained that to be successful at investing you had to first change the way you thought about stocks; rather than looking at the numbers going up or down, instead you need to think of them as representing a partial ownership in a business. And you you needed to let the market serve you, not guide you.  But for the new investor, probably the most important thing they need to understand is how to determine a stock’s ‘margin of safety.’ Once they have grasped this concept they will be better equipped to make investment decisions with a lower level of risk.

What Is Margin of Safety?

According to the father of value investing, Benjamin Graham, the term “Margin of Safety” refers to an investment principle “in which an investor only purchases securities when the market price is significantly below its intrinsic value.” This means that if a stock is valued at $10.00 per share, for example, but is trading at $6.00 per share, the difference between the two prices would be considered the margin of safety. In short, the further a stock’s price dips below its intrinsic value, the greater your margin of safety will be.

The trick is properly calculating a business’s intrinsic value.

“Proper accounting is like engineering. You need a margin of safety. Thank God we don’t design bridges and  airplanes the way we do accounting.”

– Charlie Munger

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Determining the Intrinsic Value of a Stock

The basis for discovering a stock’s “margin of safety” hinges on being able to ascertain the business’s estimated intrinsic value. We use the term here ‘estimated’ because it is literally impossible for anyone (including the most astute and experienced investors in the market) to be able to determine the exact intrinsic value of a business. This is because the intrinsic value is generally based on assumptions; the investor can only be expected to make an educated guess in this regard. This means that learning how to determine the margin of safety is of extreme importance when evaluating the investment opportunities before you. Your margin of safety will give you a certain amount of protection and allow room for error in light of the many fluctuations that could occur under the current market conditions.

So, how do we determine intrinsic value?

Investment gurus suggest that you look at stocks that hold plenty of tangibles (cash, property, inventory, etc.) rather than focus on those things that are hard to measure. Intellectual property, for example, may be of a certain value but it may be difficult to measure in plain old dollars and cents. By always buying your stocks when they are at a significant discount in comparison to their current business value, and by replacing current holdings as better bargains arise, you can maintain a pretty wide margin of safety. This could, in fact, keep you from experiencing any devastating losses even if the stock market numbers plummet.

Experts suggest that a margin of safety of 40% or more of the intrinsic value is usually sufficient. As an investor, you may choose to search out a wider margin for added security. At any rate, the general rule of thumb is that the wider your margin of safety, the less risk you’ll have of losing your investment. This does not, however, guarantee that you won’t lose money on your particular investment, but only that your risk of loss would be severely reduced if you demand a margin of error when you set your floor price.

How to Find the Best Deals

According to Benjamin Graham, the best way to find those bargain stocks with a wide margin of error is to look for companies that have tangible assets that are exceeding their current market value. When this concept was first introduced in the early ’70s, these types of deals were relatively easy to come by. However, as more and more investors learned of this strategy and entered the market, they became more difficult to find. This doesn’t mean that finding that safety net is impossible; there are plenty of ways to discover these stock market gems.

An example of such a deal took place in the early 70’s with the Washington Post, at a time when the publisher saw their prices plummet due to interactions with a number of different media companies. The entire company was trading at $100 million in market value, but Buffett anticipated that with a fire sale of its assets they could actually bring in as much as $400 million. This would create a margin of safety of 75%. Based on his conclusions, he invested $11 million dollars in 1973. Today his $11 million investment has grown to more than $1 billion.

Some might, at this point, wonder how Mr. Buffett could possibly determine the actual value of the assets in a company that he did not own? The answer is simple. With a little research he determined the value of the assets by making a comparison of similar businesses and what they were willing to pay for those same assets over the years.  Analysts say that had his margin of safety been off by a mere 25%, he still would have earned more than $300 million on his investment. Because he had such a large margin of safety, however, a high return in his investment was virtually guaranteed.

Using a combination of tangible assets and future free cash flow is the route to finding the right intrinsic value.  Once an intrinsic value is determined through asset value and discounted cash flow analysis.  At this point one would need to maintain the analysis and exercise extreme patience in waiting for the security to trade well below the calculation of intrinsic value.  Essentially waiting for the perfect pitch.

Below are sites you can find FREE screens to helping you find these types of investments:

Businesses Trading Below Tangible Book Value: GrahamInvestor.com

Businesses Producing Excess Free Cash Flow: OldSchoolValue.com

The Importance of Determining the Intrinsic Value

Many people do not completely realize that the margin of safety and the intrinsic value of a particular stock go hand-in-hand. If an investor is not able to determine the intrinsic value of a particular business, their margin of safety will be off and their level of risk will also be affected accordingly. They must, also, consider that even if their estimations of the intrinsic value are within realistic limits at the time of investment, they will still have to closely monitor how the business is performing. As the business performance changes so will its intrinsic value. As you measure these changes you’ll have to determine if your margin of safety is still wide enough for you to continue to hold your position, or if you decide to begin selling off your shares. This is why you must also search out businesses that have sustainable competitive advantages.

Another Factor to Consider

While it seems that the margin of safety idea is a sure-fire way for investors to hedge their bets, they do need to determine one other factor before making their decision to invest in a particular stock. It is extremely important that you understand the reasons behind why the stock is being undervalued. Making investments always carry a level of risk, so the more you know about why a stock has performed a certain way the better your chances of making a wise investment decision. When choosing these types of stocks, look for the underlying reasons why the stock has arrived at its current price.  This may require you to look at management styles and businesses where managers have a personal stake in the business.

Remember to Diversify — Not De-Worsify

Once you’ve determined that a particular stock has a high margin of safety and you’re ready to invest, resist the temptation to dump your entire nest egg into the decision. By nature, a stock may be strong and promising one day and then plummet to the earth the next. There are many things that can affect the price of a particular stock and you’ll need to keep abreast of its performance. It is best to diversify and spread your investment over a number of possibilities in order to make sure that you will continue to see your money grow.

An important rule of thumb is to never have more than 20 stocks in your portfolio. At this point, studies have shown that you begin to mirror the major indices with more than 20 stocks in a portfolio. Less than 5 may be too little for most investors to stomach. I, myself, tend to be more focused. I have invested my money on more than one occasion with that single position being more than 15% of the overall portfolio. I have gone over 20% on individual businesses, a few times as well. You must have an incredible temperament, long-term horizon and staying power in order to invest in such a focused manner.

When it comes to investing in the stock market it is important to be realistic about your expectations. While having a margin of safety can definitely work in your favor, nothing is guaranteed. As explained by Sham Gad in an article he wrote for Motley Fool, “Even the most astute investor can get burned by the market’s whims. A satisfactory margin of safety gives you the next best thing, and a value investor always demands it from his or her investments.”

Conclusion

In short, to be successful in the stock market you need to recognize the basic principles that have been proven over the years. Treat investing like you would any other business, and you’ll soon notice that your investments will perform accordingly. Once you learn how to choose investments with a wide margin of safety you’ll be able to gain confidence in your decisions and have pride as you watch your money grow.

Invest Different!

References:

Margin of Safety Definition

Sham Gad Quote

Photo Courtesy of Boston College and Carroll School of Management

Margin Of Safety Investing