Margin Of Safety Principle

Came across a good article. Just reproducing the work here. This post talks about the Value and Price difference of some investment .

Margin Of Safety Principle

In his book, The Intelligent Investor, Benjamin Graham describes the concept of margin of safety as being an essential part of any true investment. He goes on to say that margin of safety is an element of investing that can be demonstrated quantitatively with sound rationale and from a historical perspective.

Graham’s definition of margin of safety is essentially the gap between price and value. All else being equal, the wider the gap between the two, the greater the safety level. Graham also explains that the margin of safety is important because it can absorb mistakes in assessing the business or the fair value of the enterprise.

As Graham says – “The buyer of bargain issues places particular emphasis on the ability of the investment to withstand adverse developments.

For in most such cases he has no real enthusiasm about the company’s prospects…If these are bought on a bargain basis, even a moderate decline in the earning power need not prevent the investment from showing satisfactory results. The margin of safety will then have served its proper purpose.”

From its origin, the calculation of margin of safety was never related to the volatility of the stock price of a company. The focus of most value investors has always been based on the intrinsic worth of the company in question–a bottom-up process that should be done without regard to current market valuation (which very few analysts are willing to do).

Even with a margin of safety, an investment can still go bad. This is not a failure of the concept of margin of safety principle, as the concept only provides assurance that the odds are in the investors’ favor that they will not lose money. However, it is not a guarantee that the investors will not lose money.

There are and have been many adjustments to Benjamin Graham’s margin of safety concept in the modern era. The way that Benjamin Graham calculated margin of safety years back was very asset-based, and probably quite different from how analysts today would make the calculation.

It is the inclusion of the concept that is important in one’s assessment of an opportunity, rather than the actual mechanics and particulars of the safety calculation.

Some value investors use a variety of measures in determining a firm’s safety levels. They are as keen on asset values as on earnings and cash flow, and may even consider intangible asset values like brands, reputations and intellectual property.

They also use a variety of measures just in case one of them does not hold up–the objective is never to be caught off guard. Based on these criterion, these value investors look for several different measures, such as break-up value, favorable dividend yield, price to cash flow, and discount to future earnings as supporting casts to Graham’s margin of safety principle.

Buying companies with a margin of safety prevents owning companies with a high burden of proof to justify their stock valuations. When a stock trades at a high valuation level, the expectations are so great and often so specific that a slight disappointment or an adverse change in expectations could be catastrophic. Buying shares with ample safety means buying stocks with the lowest possible burden.

Value investors also believe that margin of safety should incorporate an investor’s appetite for risk. The disparity of safety levels among investors is based on the amount of volatility they are willing to tolerate, the mistakes they are willing to accept, and perhaps the financial pain they are willing to endure.

The margin of safety principle essentially asks the question: What is supporting the stock price at its current level? or, Why shouldn’t the stock fall significantly from today’s current price? The Graham margin of safety is heavily conscious of what can go wrong, and not what the discount is to its fair value–the safety is thus purely based on the liquidation value of the current assets.

WallStraits uses the concept of margin of safety, with a debt of gratitude to Professor Graham–but we shift the primary focus from asset valuations to discounted future earnings. Our method is less tangible today, but more valuable as a predictor of tomorrow.

Because our DCF method entails making several important predictions 10-years into the future, we require a large margin of safety–perhaps 50% or more. Luckily, in a bear market environment, such as Singapore is currently experiencing, there are several fine businesses discounted by over 50%.

Upon satisfying the 50% discount to future earnings, WallStraits moves on to evaluate dividend yields (after tax), payout ratios, cash and debt levels, brand values, sustainable competitive advantages, management capability and other fundamental aspects of each business being considered for our portfolio.

We place rather equal emphasis on quantitative and qualitative issues. This differs from Graham’s search for pure quantitative net-nets (a price equal to the firm’s current assets less all liabilities–placing current value squarely on the value of property, plant and equipment).

Graham’s most notable student, Warren Buffett, demonstrated how vital it was to consider both the quantitative asset valuations and the qualitative business assessments to find true value stocks.

Buffett favored the discounted cash flow valuation because it included both the ability of a business to generate cash flow from tangible assets, as well as the ability to create value from intangible assets–like brand strength, intelligent management, and consumer monopolies. Buffett made famous the expression–I’d rather pay a fair price for a good business than a bargain price for a fair business.

WallStraits agrees that the ultimate investment is one undervalued versus its ongoing ability to produce profits and reward shareholders.

You can use your own logic and creativity to make personal assessments of the qualitative and quantitative forms for any business you consider for your portfolio–but regardless of your methodology–don’t forget to always think from the perspective of seeking large margins of safety.

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