Margin of Safety – The Key to Value Investing

“If you were to distill the secret of sound investment into three words”, wrote Graham in Chapter 20 of The Intelligent Investor, “we venture the motto, MARGIN OF SAFETY.” Simply put, Graham’s margin of safety is the difference between a stock’s price and its intrinsic value. In theory, the further a stock’s price is below its intrinsic value, the greater the margin of safety against future uncertainty and the greater the stock’s resiliency to market downturns. The majority of investors will encounter variouse stumbling blocks and bad luck over their investing lifetime; a margin of safety will provide them with some protection in terms of preservation of capital when the going gets tough.

For example, if you have initially calculated Johnson & Johnson’s intrinsic value to be $78, you might want a margin of safety from that price. Depending on your risk profile and expected annualized return from your investments, you may have set yourself a margin of safety of 25%. A 25% discount to JNJ’s $78 intrinsic value is $58.50. However JNJ closed at $62, so we do not have enough margin of safety to make a buy decision. We can continue to monitor JNJ until either the intrinsic value (by the same calculation) increases or the price drops sufficiently such that our 25% margin of safety is above the current stock price.

What else gives value investors a margin of safety? According to Seth Klarman of Blaupost Group, it is better to focus on stocks with plenty of tangibles (cash, property, inventory) rather than intangible assets such as goodwill, intellectual property. Klarman published an entire book devoted to the subject of margin of safety in 1991: Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor
This 249 page tome is out of print and sells for upwards of $600 although downloadable scanned copies have inevitably found their way onto the internet. How does Klarman think value investors can ensure they have a margin of safety?

“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.) By replacing current holdings as better bargains come along. By selling when the market price of an investment comes to reflect its underlying value and by holding cash, if necessary, until other attractive investments become available.”

“Since investors cannot predict when values will rise or fall,” writes Klarman, “valuation should always be performed conservatively, giving considerable weight to worst-case liquidation value as well as to other methods.”

“Investors should pay attention not only to whether but also to why current holdings are undervalued. It is critical to know why you have made an investment and to sell when the reason for owning it no longer applies. Look for investments with catalysts that may assist directly in the realization of underlying value. Give preference to companies having good managements with a personal financial stake in the business. Finally, diversify your holdings and hedge when it is financially attractive to do so.”

The statement regarding “replacing current holdings as better bargains come along” is an interesting but salient point. If a value investor wishes to preserve and maintain his Internal Rate of Return, he should always be on the lookout for other valuation bargains in terms of margin of safety. It is not enough to find one bargain a year and then ignore it and the entire process – one must actively be on the lookout for something better.

Catalysts that may assist directly in the realization of underlying value could include takeovers, and these often occur in companies with lots of tangible hard cash on the books.

This entry is part of a series, Value Investing In Practice»