Margin Of Safety - Is It A Method Or A Mindset?

November 9, 2017

Margin Of Safety – Is It A Method Or A Mindset?

  • Many would like the formula for calculating intrinsic value and deriving a margin of safety.
  • I’ll discuss a few issues about the margin of safety that are mostly up to one’s personal preferences.
  • There are also some issues with a margin of safety. It’s not really free.



Introduction

I get lots of questions about how to properly value a company, what the best method is to determine intrinsic value, what clear buying signals look like, and especially a lot of questions on the best valuation metrics and financial indicators to use.

I completely understand where these questions come from as it’s in our nature to simplify things and look for the magic formula that has all the answers, especially in an uncertain environment like financial markets are. However, investing and especially value investing, isn’t that easy.

In today’s article, we’ll discuss the issues surrounding the margin of safety concept and, by the end of this article, you’ll see what the best fit for you is.

Margin Of Safety

In short, a stock with a margin of safety means that the stock price is trading at a discount to its intrinsic value due to some kind of temporary negative sentiment on the market. An investor that looks for a margin of safety is firstly concerned with their risk, and only secondly with their returns.

The margin of safety can come from an investment’s accounting value, the intrinsic value, or from various comparisons to similar stocks.

As with any kind of stock market valuation, most analyses are usually wrong and thus, by buying a stock that is trading at a discount to its accounting or intrinsic value, an investor is protected from the downside.

Figure 1: The margin of safety. Source: NYU.

However, finding a margin of safety is complicated, and there are some issues related to the matter.

The Calculation Of The Intrinsic Value

In my article about calculating intrinsic value, I described how to get to it but also that the intrinsic value of each stock is different for everybody. Further, it’s also logical that it’s different as the person selling the stock has a completely different feeling about it than the buyer.

The unfortunate point is that it’s all an estimation and one with variable time horizons. Nevertheless, in my article about the recent Nobel prize winner Richard Thaler, I mentioned hyperbolic discounting which states that people tend to heavily discount anything that will happen in the distant future. Therefore, it’s logical that differences in valuation arise, but by buying with a margin of safety to the intrinsic value, you allow yourself a margin of error.

This leads to the second, often contested, margin of safety issue – how large should the margin of safety be?



How Large Should The Margin Of Safety Be?

That again depends on your investing preferences. A person that doesn’t like risk and likes staying in cash will look for very large margins of safety that will practically eliminate any probability of long term capital loss.

As an example, Seth Klarman is currently thinking about returning money to investors as he is finding it very difficult to deploy the $30 billion his fund has under management with a sufficient margin of safety. He has done this before, in 2010 and 2013. Of course, most of us don’t have $30 billion to manage, but you get the point. Therefore, it’s again up to you to determine how large your margin of safety should be in relation to your risk appetite. The higher your risk appetite, the lower the margin of safety. This leads to the next issue related to margin of safety investing, the cost of it.

Margin Of Safety Investing Comes At A Cost

The higher the margin of safety you seek in an investment is, the larger your cash position will be, and we all know what the returns on cash are at the moment. Thus, by waiting for large margins of safety, you forgo many other investing opportunities that might have also been pretty safe and led to nice returns. So, it’s again a question of personal preference.

Margin Of Safety & Valuations

The current 10-year Treasury yield is at 2.5%, which isn’t as low as it was a year ago but it’s still extremely low when compared to the past. With such low yields, is it rational to seek investments that provide a margin of safety and a 10% return or above, or should you be happy by owning a stock that has a margin of safety in relation to the market? I happen to still prefer the first option as by looking all around the world, it is still possible to find cheap investments. But again, that’s according to my taste. Yours may be different.

Another issue with a margin of safety is whether it should be the same with all investments, or different in relation to various degrees of risk. Here I tend to go for the second option as when I look at an undervalued miner, I expect that a lot of things can still go wrong and significantly lower my margin of safety. When I’m looking at a case of a stable household company, the margin of safety can be much greater.

Margin Of Safety As A Measure Of Risk

Another common concern surrounding margin of safety is whether it can be used as a measure of risk.

From my opinion, risk is a function of the price you pay in relation to the value you get and the larger the margin of safety, the lower the risk should be. However, nobody can guarantee that the stock price will ever be fairly valued by the market or that it won’t become an even bigger bargain. Therefore, a margin of safety shouldn’t be used as a risk measure.



Margin Of Safety Is A Mindset, You Either Like It Or You Don’t

The point is that margin of safety investing is totally related to personal preferences. You either like it or you don’t and there is a precise line in between.

Further, if you put 10 value investors in a room, all of them would have a completely different idea about a stock, but that is again the beauty of investing.

So, to conclude, try to find your own methods of measuring intrinsic value, margins of safety, risk, and portfolio allocations as it’s different for all of us.

It has been scientifically proven that value investing and a margin of safety lead to higher returns over time, the bad thing is that very few investors invest a few years into their investing education in order to get to the right mindset to profitably invest over the long term.