Margin Of Safety Principle

POSTED BY manish ON March 17, 2009 COMMENTS (10)

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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10 replies on this article “Margin Of Safety Principle”

  1. Neel Patel says:

    Like this post & hope you’ll write more post related to smart investing from different books. This type of post gives idea about principles of author & some value investing tips.
    Keep it up..!!

    1. Neel

      Sure , I will try to write more .

      Manish

      1. Micheal says:

        I want to learn more on common Bond.. please get back to me it an assignment in school.

        1. What do you want to learn ?

  2. manish says:

    @Sundar

    Great work .. I am sure Nifty is over valued at the moment . However , In short term , Markets can behave weird and the movement can be not per the logic , It runs on emotions , and because of this It would be very difficult to control your original decision .

    Manish

  3. Manish Chauhan says:

    Rajnish

    Congrats to you first of all to take such wise decisions at early stage .

    The First thing is that you have not gone through my blog articles completely .

    All your questions are answered in my articles at some place , there is a seperate article for how to choose mutual funds etc ..

    I recommend you to go through all the articles mentioned here : https://www.jagoinvestor.com/2009/03/best-articles-of-this-blog.html

    If you are satisfied with 12% CAGR for next 20-25% , you can just go with 3-4 good Equtiy or Balanced funds, you dont need to be worried to pick the best one because 12% is very acheivable with your time horizon with average performer .

    The other thing is that every goal should be planned seperately and you should pick appropriate financial vehicale for it . In case you want to buy House in next 2-3 years , Equity wont be a good idea , as there is more risk than you should take for this important goal . but if your risk appetite allows very high risk , its fine .

    Manish

  4. rajnish kumar says:

    thanks for your nice suggestion manish. i have no knowledge about market and mutual funds. can you suggest good mutual fund where i can invest for 20-25 years for anual CAGR of 12% and above.what to keep in mind while choosing mutual fund.my horizon is for long terms for future needs e.g. child education , marriage and house purchase. i am 27 years old and currently drawing 40000+ salary.

  5. Manish Chauhan says:

    Yes Rajnish

    You have asked a good question .

    You can definately choose a share and keep investing a fixed amount every month for a long duration . And I am sure it would give good returns over long term if choosen carefully . But before that consider followinmg things

    1. You will have to invest each month systematically from your demat account , there is no automated process for this .

    2. It would be hard to control yourself to invest systematically on same day of every month , When markets will be very high , or low , emotions come in between and its hard to take decisions.

    3. Just by choosing 1 or 2 shares you wont be diversifying well enough . Mutual funds invest in many number of good shares and hence they diversify the risk very well .

    4. If you are a general investor who does not want to be involved a lot with markets and do not have enough knowloge about markets , Better put money in MF’s only , over the long term its not easy for an average investor to beat MF’s . thats the reason why MF are there .

    So , At last if you want to really invest directly . following is the recommendation .

    Choose some good fundamentally strong Stocks (atleast 5) . and keep investing in these shares every month systematically without fail (just like SIP) for long duration.

    I hope i answered what you were looking for , if yes ,good, else ask back 🙂

    Manish

    1. sundar says:

      hi,
      i am posting a mail that i had sent to my friend explaining this margin of safety principal, and also tried to apply it to the Indian Equity market,

      Graham in his book suggests that, stocks invested at an earnings yield at-least equal to the current bond yield should work out satisfactorily for investors. based on this recommendation, lets assume,

      current bond yield = 8% . the price to earning ratio is 12.5 (Rs.100 divided by Rs.8)

      a stock with an earning of Rs.5/- should command a price of Rs.62.5/- (Rs.5 multiplied by 12.5) for it to command a yield of 8%.

      According to Graham, the average of the past three years earnings should be considered and also to take this 12.5 ratio as the maximum, and to invest at-least 20% below this for a ‘margin of safety’. so in our example,

      maximum ratio =12.5 , 20% of this value is 2.5.

      margin of safety ratio = 10 (12.5 minus 2.5).

      our hypothetical stock should work out well, if purchased at Rs.50/- (Rs.5 multiplied by 10).

      I have done the same calculation for the indices, their yield, max price and margin of safety price level for the market ( as on 11/11/09)
      yield Max Mos
      NIFTY 4.41 3392 2714

      JrNIFTY 4.83 7420 5936

      CNX500 4.76 3025 2420

      so to conclude,
      with the markets at these levels ( Nifty is trading above 5000 as of this writing), there is a negative Margin of safety.

  6. rajnish kumar says:

    sir i have one question. over past year equity market returns around 15%.so people start investing in mutual fund. but that is not under our control. can i take one scrip and go on investing every month by own directly ? e.g. take RIL. if i plan to invest 6000 monthly can i keep on puchasing every month shares of RIL worth Rs 6000 for 20-25 years. is it good idea.please advice me.

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