In chapter six of “Modern Value Investing: 25 Tools to Invest With a Margin of Safety in Today's Financial Environment,” author Sven Carlin provided what he described as “easy ways to determine a margin of safety."
First, though, he set out to define margin of safety and to explain its importance. Here are two examples where it exists or existed:
- A stock trades at $5 per share, but owns real estate worth $10 per share, providing a 50% margin of safety.
- In October 2008, one in eight stocks traded in the U.S. were trading at prices below their cash per share value, without even including real estate values.
In Carlin’s definition, margin of safety is about risk minimization, not profit maximization. “The point of the margin of safety is to find investments where the likelihood that you lose money in the long term is minimal,” he wrote. Ultimately, of course, profit maximization is more likely when risks are minimized.
While opportunities to find stocks with a solid margin of safety occur less often in bull markets, there are some available for investors whose traits include:
- Discipline, to resist the temptation of the newest market fads.
- Hard work, since it is necessary to screen thousands of stocks and then carefully assess those that indicate potential. Expect the stock to be fairly priced, even if that price is below book value.
- Patience, waiting while the market comes around to your valuation, to hold until the time is right to buy.
Again, he refers to the “essence” of a margin of safety as avoiding losses, since an investor is more exposed to the upside when the downside is limited. Investors who have a margin of safety will enjoy less risk for the same or even greater expected returns than other market players.
It is particularly helpful in a bearish market; as earnings decline, other investors are looking for safety and protection, which can be found only among stocks that offer a margin of safety. In addition, stocks that are already bargain-priced and have a margin of safety usually have less room to fall than high-flying stocks thanks to their fundamentals.
How big should a margin be? Carlin responded with this quotation from Warren Buffett (Trades, Portfolio): “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.”
Carlin went on to say there is no formula, because different investors have different tolerances for volatility. It also depends on how much risk individual investors are prepared to take on. In the real world, this may involve trade-offs or compromises. The larger the margin of safety demanded, the fewer the stocks available.
At the same time, this will depend to some extent on an investor’s time and access to research tools—the more stocks that are researched, the greater the odds that stocks with a margin of safety can be found. Carlin wrote, “The focus lies here both on the analysis and focus. The bigger the database of stocks that you have analyzed, the easier it will be to follow them and act when their prices fall into your required margin of safety range.”
Constantly comparing stocks, then, should become a practiced routine for value investors. They will also need to hold cash so they can respond quickly when attractive stocks with desired margins of safety appear. How much cash is always a difficult question, since there is an opportunity cost (not earning returns elsewhere). Carlin worried that investors might relax their criteria so much as to make investing mistakes. Discipline and hard work are necessary to “invest with confidence.”
The author went on to propose buying in stages as one way to approach margin of safety. For example, investors make a small purchase when the margin of safety is 20%, or larger purchases if the margin of safety is 40% or 60%. This has the added benefit of providing time to get to know the company as an owner.
A couple of other points arise out of guru quotations within the chapter:
- “The function of margin of safety is, in essence, that of rendering unnecessary and accurate estimate of the future” -Benjamin Graham
- “Value investing is the discipline of buying securities at a significant discount from their current underlying values and holding them until more of their value is realized.” -Seth Klarman (Trades, Portfolio)
Graham was telling investors that a margin of safety provides a cushion against the inevitable mistakes that will be made when assessing the future. Whether that involves the fundamentals or a loss of favor in the investing community, investors are less likely to suffer large or permanent losses if they start with a margin of safety.
Klarman wanted investors to know that deferred gratification is the lot of value investors. By extension, it might be argued that value investors can substitute discipline, hard work and patience for risk-taking.
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
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