Value Investing Foundation 2: Margin of Safety. Explained.

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Margin of safety is the basis of value investing strategy.  The father of value investing, Benjamin Graham proposed in The Intelligent Investor that “to distill the secret of sound investment into three words, we venture the motto, “MARGIN OF SAFETY”  Seth A. Klarman, a disciple Graham and famous value investor himself literally wrote the Margin of Safety book.

What is a margin of safety?

In our value investing foundation article we wrote that value investing is about buying a stock at a sufficient discount to intrinsic value. Buying a stock at a significant discount to its intrinsic value allows the investor to have a “margin of safety.”

To help construct a margin of safety definition, Graham contends, “We have here, by definition, a favourable difference between price on the one hand and indicated or appraised value on the other.  That difference is the margin of safety”  Graham explains that a margin of safety can only certain if reasonable and rational analysis can demonstrate that the price paid for the stock is substantially less the value of the underlying assets.

Warren Buffet describes this succinctly, “Price is what you pay.  Value is what you get.”  The value investor looks to pay a price much less than the value received – and that difference is the margin of safety.  In other words, value investing is about buying a dollar for fifty cents – therein lies the margin of safety.

Very simply, Joel Greenblatt explains in The Big Secret for the Small Investor that the concept of margin of safety is about “leaving a big space between the value of what you are buying and the price you pay.”

Why is a margin of safety important?

In Margin of Safety, Seth Klarman explains “that value investors seek a margin of safety, allowing room for imprecision, bad luck, or analytical error in order to avoid sizable losses over time.  A margin of safety is necessary because valuation is an imprecise art, the future is unpredictable, and investors are human and do make mistakes.” Buying a stock with a significant margin of safety reduces both the likelihood and severity of potential losses.

Value investors don’t just like to avoid losses though – they still like to make money, of course.  Graham wrote, “A strong-minded approach to investment, firmly based on the margin-of-safety principle, can yield handsome rewards.”

How do we get a margin of safety?

“The margin of safety is always dependent on the price paid,” writes Graham.  “It will be large at one price, small at some higher price, nonexistent at some still higher price.”

Klarman says that investors achieve a margin of safety, “By always buying at significant discount to underlying business value and giving preference to tangible assets over intangibles.”  Much of a potential return is earned as the price of the stock begins to reflect the underlying value of the assets.

In order for the gap to narrow, the investor must try to first understand why the discount exists and second, whether there are any catalysts that will help the stock rise to reflect the true underlying value.

Conclusion

Margin of safety is the central theory of value investing.  First and foremost, a margin of safety first helps ensure the goal of preservation of capital and loss mitigation. It is about buying securities at substantial discounts to their actual value and then maintaining these holdings until the mispricing is eliminated by the market (or unless other information becomes available that could change the original investment thesis), thereby earning the value investor satisfactory returns.

So, what we must do

  1. Buy stocks at a certain price and never over that ‘value’ price
  2. Stocks go up and down so, it makes sense to put multiple limit orders down, so that u get maximum advantage of volatility
  3. Buying high conviction stocks all the way down to increase margin of safety
  4. Assign a ‘Value’ for each stock qualitatively and buy only below that
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