Safety margin; How to ensure returns from your stocks
“Value investing is trying to buy a dollar for fifty cents”
– Warren Buffett
The core principles of value investing revolve around the price at which an investor purchases securities. Because for value investors, what they buy is equally important as how much they buy it for.
That’s where the margin of safety comes in.
What is the margin of safety?
The margin of safety is a principle in value investing that encourages investors to buy stocks at a price significantly below their fair value. The term margin of safety was coined by Benjamin Graham, who is also known as the father of value investing. However, the term was popularized by his student and one of the most popular investors ever, Warren Buffett.
The margin of safety aims to reduce the downside risk of an investment, thereby increasing the chances of making a profit.
How does Margin of Safety work?
Calculating intrinsic value (also known as fair value) is the first step in determining the safety margin. It is calculated by taking various aspects of the underlying business into account; assets and earnings, management, industry outlook, etc.
Once you have the intrinsic value of a stock, you can set the margin of safety. The safety percentage varies from one investor to another, based on their risk tolerance. Some go for a margin of safety of 20%, meaning they set their target purchase price 20% below the stock’s intrinsic value. Meanwhile, some investors go for a higher margin of more than 50%.
Remember, it’s not 20% below its market price, but 20% below its intrinsic value. For example, suppose AMD trades at $100 a share, and as per your calculations, it has an intrinsic value of $80. So that means AMD is trading above its intrinsic value.
So an investor looking for a margin of safety of 20%, would set his/her target price at $64, 20% below its intrinsic value, $80. That means, the investor purchasing at $64 is likely to see an upside of more than 25%, as he has managed to buy the stock significantly lower than its market price.
However, it also means that the investor will need to wait for a while for the stock to come down to the discounted price of $64 from $100. At the same time, he also needs to make sure such a drop is not the result of deteriorating fundamentals.
Because often it could be due to a problem in the underlying business. If you go ahead and buy the discounted stock without re-analyzing the fundamentals you may end up in a value trap.
Using the Margin of safety
The margin of safety is incredibly useful in limiting downside risk. The margin of safety ignores the stock price. Instead, it looks at the intrinsic value of the stock and applies a discount on it, thus setting the target purchase price.
This highly increases your chance of making a profit from the stock. Take the case of AMD, for instance. AMD is currently trading at $100. If you can wait long enough to buy it at the price of $64, which is the target price as per margin of safety, you’ll enjoy a good profit from the stock.
At the same time, it also reduces the chance of incurring a loss. As you’re buying the stock for a price significantly below its market value, it’s unlikely that you’ll incur a loss.
Warren Buffet explains it perfectly; “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”.
Buffett is trying to say that you shouldn’t buy a stock that’s worth $100 for $90. You need to leave more room for human error in valuation, extreme volatility, or just bad luck in the market. So you buy it for $80 or $70, leaving sufficient room for error. And that’s how the margin of safety works.
To understand the margin of safety, let’s see how the intrinsic value of a stock is calculated. Some use discounted cash flow to calculate the intrinsic value, while some others take advantage of metrics such as Earning power value, absolute PE, or even the Graham formula.
But the truth is, intrinsic value is highly subjective. No matter how many variables you use, there’ll always be assumptions.
Hence, the margin of safety.
Because, what if the assumptions are wrong? How do you make sure that your assumptions don’t hurt your investment?
So you focus on the price you pay.
We make sure there is enough room to cushion any downfall, in the event our assumptions turn out to be wrong. So instead of trying to buy at its fair value, like regular investors, value investors apply a margin of safety of 20% – 30% and buy the stock.
Warren Buffett and Margin of safety
Even though Ben Graham coined the term, it was Buffett who popularized the concept.
The margin of safety perfectly aligns with the value investing philosophy Warren Buffett so profusely preaches. While value investing is aimed at finding undervalued stocks, the margin of safety acts as an additional cushion, to limit the downside.
The market price or share price has little or no significance when it comes to the margin of safety, It is calculated purely based on what it’s worth, that is intrinsic value. So even if the stock is currently trading below its intrinsic value, the margin of safety would still be applied to the intrinsic value.
The margin of safety is one of those concepts that most investors gladly ignore. Thanks to social media, investors these days only care about what’s hot – stocks and industries alike. But as a long-term investor, your objective is not to look for what’s hot. But look for stocks that can provide value to your portfolio. And that’s what value investing is all about.
And the margin of safety is will help you make sure you take care of the downside risk as well.
And if you’d like to know the 20 stocks we think you can hold for the next 20 years, check out our bestselling book The 8-Step Beginner’s Guide to Value Investing.
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