What is Margin of Safety?

Origin of ‘Margin of Safety’

The term ‘Margin of safety’ was coined by the famous founders of Value Investing, Benjamin Graham and David Dodd, in their book ‘Security Analysis’, which was published in 1934. It has also been described and discussed about in the 1949 book ‘The Intelligent Investor’ by Benjamin Graham.

Meaning of Margin of Safety

A major principle in the field of investing is the Margin of Safety (MOS), according to which an investor should only purchase securities when the market price of those securities is much below the intrinsic value of those securities. The Margin of Safety is basically the quantum by which a company’s shares are being traded below their true (intrinsic) value in the market.

Essence

This principle facilitates the investor a margin of safety in accordance with his/her own risk preferences. While purchasing securities the investor can decide with a clear vision about what is the minimum and maximum risk that he/she hasto take in order to gain returns. The presence of a margin of safety allows for an investment to be made in a way that is safe for the particular investor.

Accounting and MOS

In the field of accounting, the margin of safety means the difference between the actual sales of a firm and the breakeven sales of a firm. This knowledge is used by the managers to determine the minimum sales before the venture becomes unprofitable or starts making losses.

Understanding the Difference between Price and Value

Generally, the value estimated by the investors and the market price of a stock are close to each other, apart from the daily fluctuations in the market. However, there is a conceptual difference between the value and the market price of a share. Price is essentially what we pay to own the stock. On the other hand, value is what we receive due to the ownership of the share.The concept of getting more value that what one is paying is fundamental to the principle of Margin of Safety.

Importance of Margin of Safety in Investing

The world is rapidly changing around us and to overcome the risks of high volatility, mischance, imprecisionin the true valuation or the calculation of the intrinsic value of a security and human errors that may amount to huge losses, investors seek a Margin of Safety to safeguard the future of their investments.

• Human errors are natural, even in the field of investing. The Margin of Safety keeps the investors better protected against the risk of human mistakes in the estimation of the value of a company’s shares.
• Margin of Safety provides the investors with a cover against global risk factors as well as the factors that they may not be able to control due to high volatility in the market.
• There are some risks which we are known of while some, otherwise. The risks, that we are not aware of, were termed as the “Unknown – Unknown” by Benjamin Graham. The Margin of Safety provides protection against these risks as well.
• Most of the valuations are based on certain assumptions which may as well prove to be wrong. Margin of Safety shields the investors from these blunders.

How to Reckon the Margin of Safety

Formula for Margin of Safety (MOS):

For example;

An investor believes the intrinsic value of a share to be Rs. 500. The investor buys the share at the market price of Rs. 400 only.

Hence, MOS = 1 – (400/500) = 0.2.

Therefore, the Margin of Safety is said to be 20%. This is because the investor has paid only 80% of the intrinsic value of the share. The rest is attributed to the Margin of Safety.

Where can an Investor find a Margin of Safety?

Some of the situations in which an investor can find a wide margin of safety are:

• Deep-value Investing–When an investor buys shares from a very undervalued business, where the main objective is to find a large gap between the intrinsic value and the market price of the securities, he/she can find a wide margin of safety. This is a peculiar situation since in reality investing in such shares can prove to be risky.

• Positive Growth at Feasible Price Investing –When an investor buys shares from a company which grows at a positive rate yet somehow the shares of which are being traded below the intrinsic value, he/she can find a wide margin of safety.

Warren Buffett’s “Bridge" Analogy

Warren Buffett, an American business magnate, investor, speaker and philanthropist, is one of the most successful and famous disciples of Ben Graham.

He compares the concept of Margin of Safety with the construction of a bridge across a river. He says that when a bridge is built, it is built powerful enough to hold a 30,000 pound truck load despite the knowledge that only 10,000 pound trucks will be driving across it. The same principle is applicable in the area of investing, termed as the Margin of Safety.

The larger the river, the larger the margin of safety will be required. Similarly, when we are aware of the future of the business and understand it fully, we may require lesser margin of safety. However, the more vulnerable the business is, the more margin of safety is required.

How to Make Sure you have a Margin of Safety: Seth Klarman

The esteemed value investor and writer of  the 1991 book ‘Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor’, Seth Klarman says that an investor should always buy at a significantly low price than the intrinsic value and give preference to tangible assets over intangible assets. Not that there are not great investment opportunities in businesses with valuable intangible assets. Investors generally cannot predict when the values will rise or fall. Hence, the valuation of the shares should always be done in a conservative manner, giving sufficient consideration to the worst case scenario of liquidation.

How to Make Sure you have a Margin of Safety: Benjamin Graham

According to Benjamin Graham, the “father of value investing”, an investor should not run after momentum stocks (the stocks which are popular in the market), rather go for the less popular stocks in the market which have a lower multiples of the ratio of price to earnings (P/E) or of the ratio of price to book (P/B).

The investor should carefully analyze the balance sheet of a company, including all its components, so as to understand whether the company has any hidden assets which have been potentially overlooked by the others.The investor should appreciate the importance of patience and long-term vision, two essential virtues in value investing, because the share prices of companies with very low P/E or P/B ratios can remain sunken for a very long time. However, the investor is likely to be very successful in the long-term.