One of the worst feelings in the world is when you purchase a stock and immediately it goes down. Let’s say that the stock drops 25%! Yikes. You think to yourself, what have I done? Why did I buy this and what am I going to do?
How do we protect ourselves from this ever happening to us? First of all, there is never any complete protection from this happening. It happens to the best of us but the trick is to try to minimize your loses and protect yourself by giving yourself a margin of safety.
[This is a guest post by Dave from IRA for Beginners. His favorite phrase is Knowledge is power. He has a passion for investing and helping people learn how to save and invest for the future.]
Okay, so what is a margin of safety?
A margin of safety is principle of investing that in which you the investor will only purchase a stock if it is below its intrinsic value. This means that if the market price is below your estimation of the intrinsic value of the stock, the difference would be your margin of safety.
The bigger the difference the larger the margin of safety. Warren Buffett used to insist on a 50% margin of safety when he was purchasing stocks.
Let’s give an example of how this works.
Say you find a company that you really like and the market price is currently $100. You feel like that is a fair value but based on your intrinsic valuation you determine that your price would $75. Now you want to put a margin of safety on that price. So you determine that you are willing to buy it a 25% margin of safety, which would be $56.25. So you wait until the price drops to your target of $56.25. Once it hits that mark you can buy with confidence.
Keep in mind this means that you might not be able to buy the stock for a while and patience is a key to this strategy. Also know that you need to ensure that there is not some reason for the decline, like a sharp drop in earnings.
Next question. What is intrinsic value?
“The intrinsic value is the actual value of a company or an asset based on an underlying perception of its true value including all aspects of the business, in terms of both tangible and intangible factors. This value may or may not be the same as the current market value.”
Intrinsic Value Definition by Investopedia
The last sentence of the above definition is key. We are always looking for safer bets when we are searching for companies to buy. So it’s imperative that we find bets that are below the intrinsic value.
The market is going to price the stock according to its whims. Mr Market will go up and down as he sees fit. Our goal is to find the best bets that we can and take advantage of those opportunities.
Practitioners of Margin of Safety
Let’s talk about some of the most important figures that have shaped and championed margin of safety.
He is the father of the margin of safety. Graham taught at Columbia Business School, which is where he encountered his most famous pupil, Warren Buffett.
As well as being a wonderful teacher and author, he was also a terrific investor in his own right. Rumor has it that he was wiped out in the crash of 1929. But he learned some valuable lessons from that experience and his partnership was able boast annual returns of 17% until its termination.
In 1934 he co-authored the seminal “Security Analysis”, which is considered an investment classic. This was considered the nuts and bolts of his strategy. He lays out his mathematical ideas in Security Analysis. It was the genesis of financial analysis and corporate finance.
Keep in mind that this was prior to the age of the internet. So any analysis was done the old fashioned way. Graham had to request copies of annual reports and pore thru them manually to dig out the info he was looking for. Pretty amazing if you ask me.
This book is still used today as a foundation for teaching finance. Because of his work with the SEC, he pioneered the laws which require companies to provide financial statements that are certified by independent accountants.
He next wrote “The Intelligent Investor” in 1949. This book provided much more practical advice than Security Analysis did. And it has become one of the best selling investment books of all time. Warren Buffett describes it as “by far the best book on investing ever written”. High praise indeed.
In the Intelligent Investor Graham floated two ideas, among many that caught on with the investing world. The first was creating a fictional character to describe the mood swings of the market. The seemingly fickle way it rises and falls. He calls this fictional character “Mr. Market”
He also introduced the idea of margin of safety in your investments. His definition was to buy a stock well below its conservative value of the business. This was important because it allowed profits on the upside as the market eventually evaluated the stock more favorably, plus it allowed for an error in calculations as well as business failure.
Graham’s other claim to fame was his mentorship of Warren Buffett.
After reading the “Intelligent Investor” at the age of 19. Buffett enrolled in Columbia Business School to study under Graham. During this time they became lifelong friends.
He later worked for Graham and after his retirement, Buffett was able to take on many of Graham’s clients and the rest is history.
A few quotes in regards to Buffett’s thoughts on margin of safety.
“You have to have the knowledge to enable you to make a very general estimate about the value of the underlying business. But you do not cut it close. That is what Ben Graham meant by having a margin of safety. You don’t try to buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And that same principle works in investing.” – Warren Buffett
“Rule Number One – Don’t Lose Money
Rule Number Two – Don’t forget rule no. 1” Warren Buffett
Through the years Buffett has moved away from strictly calculating a margin of safety on an investment. As you can tell from the quotes above, he is as much about common sense as he is about numbers.
Take for example his investment in Coke. His confidence in that investment was based on his feeling that people would drink larger and larger amounts per person per day for a very long time. History was on his side as per capita consumption has been rising for years. So his margin of safety for this company was his belief in human drinking habits.
Other investments will follow the more logical path using numbers to calculate a margin of safety. He doesn’t apply a 50% margin of safety to an intrinsic value estimate. He just looks for situations where he’s confident his investment will earn an adequate return from day one and far into the future. And he wants to pay less for the stock than it is worth.
His annualized returns for the last 50 years is 21.6%
If you are interested in learning more about Buffett’s thoughts on investing, then you absolutely need to check out his annual letters to shareholders. They are an absolute must read and you will get tons of great guidance in investing. Plus they are fun to read. Really, I promise.
Legendary value investor and founder of the Baupost Group hedge fund published an entire book on the margin of safety in 1991. It is titled “Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor”.
Unfortunately the book is out of print. You can buy it on ebay or Amazon for around $1000! Yikes. I was lucky enough to be able to borrow a copy from a finance professor here in my home town. I believe it is available from some not so reputable sites as well.
Absolutely fabulous read and very well written. He spends most of the book discussing his philosophy on the margin of safety and how to achieve it.
A few quotes.
“A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world.”
“By always buying at a significant discount to underlying business value, and giving preference to tangible assets over intangibles. (This does not mean that there are not excellent investment opportunities in businesses with valuable intangible assets.)… Since investors cannot predict when values will rise or fall, valuation should always be performed conservatively, giving considerable weight to worst-case liquidation value as well as to other methods.”
“A margin of safety is [is intended to] allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world.”
He felt that it was necessary to have a margin of safety because investors screw up. A lot. Having a cushion against mistakes or stupidity is a must, especially since valuing companies is an imprecise art.
Klarman’s Baupost Group has averaged nearly 20% annualized returns since its inception.
Joel Greenblatt is a very successful value investor and the founder of Gotham Capital. He has written several books on value investing. Two of my favorites being “You Can Be a Stock Market Genius”, and “The Little Book that Beats the Market”.
One of the things Greenblatt is famous for is his “Magic Formula” which he espouses in the book “The Little Book that Beats the Market”. He even has a free website dedicated to his ideas in that book. Great book by the way.
Here are some of his thoughts on margin of safety.
“Prices fluctuate more than values—so therein lies opportunity. Why do the prices fluctuate so widely when values can’t possibly? I will tell you the answer I have come up with: The answer is I don’t know and I don’t care. We could waste a lot of time about psychology but it always happens and it continues to happen. I just want to take advantage of it. We could sit there and figure it all out, but I like to keep it simple. It happens; it continues to happen; the opportunities are there.
I just want to take advantage of prices away from value.. If you do good valuation work and you are right, Mr. Market will pay you back. In the short term, one to two years, the market is inefficient. But in the long-term, the market has to get it right—it will pay you back in two to three years. Keep that in mind when you do your analysis. You don’t have to look at the next quarter, the next six months, if you do good valuation work—.. Mr. Market will pay you.”
Some more thoughts.
“Buying good businesses at bargain prices is the secret to making lots of money.”
“Graham figured that always using the margin of safety principle when deciding whether to purchase shares of a business from a crazy partner like Mr. Market was the secret to making safe and reliable investment profits.”
“Look down, not up, when making your initial investment decision. If you don’t lose money, most of the remaining alternatives are good ones.”
From 1985 to 2006 Greenblatt averaged 40% annualized returns. Truly amazing.
There are numerous other value investors who have helped shape the direction of value investing and their interpretations of the margin of safety. Two others that I would be remiss if I didn’t mention them would be Monish Pabrai and Guy Spier. They have both written wonderful books about their experiences with value investing and their views on margin of safety. Definitely worth checking out.
How do we Calculate a Margin of Safety?
There are differing opinions on how to calculate intrinsic value of a stock. In “The Intelligent Investor” Graham suggests a formula that would get you in the ballpark, if not the final number.
First, we will need to calculate the intrinsic value and then we can apply a margin of safety to the number to determine at what point we could buy.
In his book the formula for finding value was multiplying the current earnings per share by the sum of 8.5 and twice the sum of the anticipated growth rate
V = EPS X (8.5 + 2G)
The formula was later revised in 1962 to include a required rate of return. It now looks like this.
IV = intrinsic value
EPS = Earnings per share
G = Expected growth rate
Y = current yield of 10 year Treasury notes
How to find the input values:
The current EPS for any company are available on most finance website. My favorite is Morningstar.com but you can use whoever you prefer.
The anticipated growth rate is difficult to determine and becomes a matter of judgement. Predicting future growth rates in the short or long term is extremely difficult, and this is why Graham came up with the margin of safety. To act as a buffer for errors in judgement.
For the best results use at least 5 year projections of analysts predictions. These can be found on the morningstar.com website. Look under the valuation tab and follow the link for Wall Street estimates.
And finally the yield can be determined by using the current yield on a 10-year Treasury Bills. These can be found by just Googling for the info and it will appear on the first page.
So let’s do a little test.
We will try Microsoft(MSFT)
- Current EPS $2.09
- Growth = 7.05
- Yield = 2.14
Intrinsic value equals $43.11. The current price of MSFT is $58.70.
So it is trading above the intrinsic value of the company. This means that you have no margin of safety if you buy it at its current price. To build in a margin of safety you want to purchase it below the intrinsic value. So if you are looking for a 25% margin of safety we would multiply the intrinsic value by 75% to get our value.
In this case if would $43.11 X .75 = $32.33. So that would be the price you would look for as a buy. Anything below that would be a bonus. The bigger the margin of safety the larger the margin for error in the valuation.
Pretty simple huh. Once you know where to find the numbers it is quite simple to calculate.
There is another number based formula that you can use to help determine a margin of safety. This is called the discounted cash flow method. It is a little more involved from the math side of things. We will tackle this method in another post in the future.
Margin of safety is a critical component of every value investor’s toolkit. It can be the difference between making money or losing a ton of money. If you invest without a safety net you better be sure of your convictions because the market is a very unforgiving place.
Everyone makes mistakes when they are trying to decide whether or not they want to purchase a company. It can be an incredibly nerve wracking time. But with the formula that we discussed you can have some faith that you have built a margin of safety into your valuation and that your investment can have some safety to it.
Investing is a risk and you can never completely eliminate it. But with the knowledge of what we discussed you can sleep a little bit easier knowing that you have built in a margin to hedge against any mistakes we might have made in our valuation of the company.
The Graham formula that we discussed in this post is a valuation tool. Your investments should never be based solely on this formula alone. It is meant to be one of many tools that you use to help you find great investments.
All the great investors that we discussed in this post have used these formulas and others as a framework the help them make better decisions.
As always thank you for taking the time to read this post and I hope you have found it helpful.
Until next time, Take care.