In theory
‘Margin of Safety’ are the three most important words in investing according to Warren Buffett.
It was a term first popularised by Benjamin Graham, known as the ‘father of value investing’, who once taught Warren Buffett about investing.
In his seminal book The Intelligent Investor, Graham explained that to have a “true investment” as opposed to a speculative one, there must be a “true margin of safety”. “And a true margin of safety is one that can be demonstrated by figures, by persuasive reasoning, and by reference to a body of actual experience.”
In essence what this concept recommends is that you buy an investment at a significant discount to its intrinsic value, thereby building in a safety buffer should it drop in value and/or the investment thesis prove incorrect.
Such a method of investing doesn’t guarantee that you won’t make a loss but it does vastly reduce the likelihood of your doing so, especially if the investment is held within a diversified portfolio.
In practice
So how do you achieve a ‘margin of safety’ in practice? By buying shares when they are relatively cheap or ‘on sale’. Certainly not by chasing ‘hot’, highly-rated growth stocks that are overpriced.
In practice, measuring the intrinsic worth of an investment differs according to your method of evaluation. It isn’t an exact science, more of an art.
Adherents of this approach generally tend to attach a great deal of weight to the strength of a company’s balance sheet, as earnings can be fickle and prone to cyclicality and reversion to the mean.
Graham said that "usually net-current asset values may be considered a conservative measure of liquidation value" and recommended investing in companies that could be purchased at below 66% of their net current asset value (NCAV).
NCAV per share can be calculated by taking a company's current assets and subtracting the total liabilities, and then dividing the result by the total number of shares outstanding.
A number of legendary value investors have since utilised this basic methodology (albeit with some adaptations) to find underpriced stocks that eventually rise in value; investors such as Martin Whitman, Irving Kahn and Walter Schloss. They concentrated more on the assets of an investment rather than its income stream in attempting to measure intrinsic value, and built in a margin of safety that way.
Value Investor Chris Browne, head of value investing firm Tweedy Browne, has written in The Little Book of Value Investing that he assesses the value of shares using three main criteria:
• low price to book value ratios
• low P/E ratios
• appraisal method in determining its acquisition value
Warren Buffett
Warren Buffett has specifically said that the margin of safety principle is the cornerstone of his investment success. Although, while he always attempt to buy well below intrinsic value, he is prepared to pay for quality earnings.
Buffett buys excellent businesses that are well managed, with sustainable competitive positions. Looking at the price in pence of a share is not the starting point but the end point, after having determined what the company's intrinsic value is.
For example, in the late 1980s Buffett bought $1 billion worth of Coca Cola shares at an average cost of around $11, when many ‘value’ investors considered it overvalued because its price was 15 times earnings and 12 times cash flow. Yet, by consistently growing revenues and profits, the share price reached $45 in 1992.
In trying to ensure a margin of safety, it is always important to remember that price has nothing to do with value when investing--price is merely what you pay.
The Morningstar way
At Morningstar, we approach the concept of margin of safety in a slightly different way. First, our analysts arrive at a fair value for a company, using a proprietary discounted cash flow (DCF) model, with an emphasis on the firm’s return on invested capital (RoIC).
Within that, economic moats, or a company’s sustainable competitive advantages that help ward off competition, are central to the valuation process, where, all else remaining the same technically, a wide-moat firm will enjoy a higher fair value compared to a no-moat firm.
Finally, we build in the margin of safety by employing our ‘Uncertainty’ ratings we assign to each stock. So all businesses are different with respect to the predictability of their earnings and each stock is assigned an Uncertainty rating of low/medium/high/very high.
Stocks with a Low uncertainty rating will need to be trading at a lower discount (of 20%) to our fair value to become a buy recommendation, or reach a five-star rating. On the other hand, a ‘Very High’ uncertainty stock will need to trade at least at a 50% discount to its fair value, before it gains the 5-star rating (where we believe it is trading with a sufficient margin of safety). Read complete equity research methodology here.
A version of this article first appeared on Morningstar.co.uk, our sister UK site. Nazim Khan contributed to this article.
