MARGIN OF SAFETY EXPLAINED

Posted on | February 8, 2010 | 1 Comment

If you have read any books by any value investor or a blog written by a person more inclined towards fundamental investing, you may have heard this phrase “margin of safety”. So I decided to write up a post on this very important concept in fundamental investing.

What is margin of safety?

Since it is Benjamin Graham who first came up with this phrase, it is best to define it from his point of view.

In the case of bonds, it is the security provided by the company’s ability to provide revenues in excess of the interest requirements thus protecting the investor against a slump in the economy because they will still get their interest payments. If you read about how bonds work, you will see that companies pay the bondholders their interest payments from their revenues. So the higher the company’s revenues, the more protection that the investors get if the profitability of the company was to decrease i.e. they would still get their periodical payments.

In the case of stocks, it is the difference between the real (intrinsic) value of a stock (as in what the stock is really worth) and the market price of that stock in the stock market. Sometimes the stock is overvalued in that the market price is way over the intrinsic value and sometimes it is undervalued in that the market price is lower than the intrinsic value. In the case of the overvaluation, the required margin of safety is not provided and a value investor worth his salt will not even touch that stock no matter how much the media and the general investing public is hyping it up.

A value investor will mostly look for grossly undervalued stocks because in most cases the undervaluation is not justified in that the general investing public just does not like the stock, or it is not causing a lot of excitement. A hypothetical example is a company that makes toilet seats would not be as popular as a search engine that seems to control the whole internet. You may find that the toilet seat company has much better fundamentals that the search engine and thus a much better investment.

NB;Something that any investor should know is that margin of safety is to be applied in all areas of investing, be it bonds, stocks, liquid investments, warrants…. basically anything that is included in his portfolio

[Street authority has a large well written longer article about margin of safety with more examples than this post so you would want to read thru for a better understanding]

Contrary to popular belief, it is not that easy to determine the real value of a stock and that make an informed decision as to what price it would be wise to buy the stock. So an undervalued stock provides that very necessary margin of safety to protect the investors from unexpected downturns of the market or the miscalculation in the calculation of intrinsic value of the stock. The greater the margin of safety the more protection the investor has for his money.

In insisting on a large enough margin of safety, an investor reduces the risk that he is exposed to and in most cases will not be so worried about what the market is saying about the security since even before buying it, he insisted on a margin of safety by using figures, persuasive reasoning and experience and thus according to Benjamin Graham, it becomes a true investment.

In this site called the Warren Buffett secrets, margin of safety is well explained in from an approach that is different from the one that I have taken

The first time that I heard of this term was in the intelligent investor and coincidentally simple dollar did a post on that chapter of the book dedicated to this concept that you may find helpful

Any comments or additions are welcome