Can you get a loan despite a bad CIBIL score‘Because investing is as much an art as a science, investors need a margin of safety. A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable, and rapidly changing world’- Seth Klarman, Value investor

You must have heard of the phrase,‘Better safe than sorry’.

Like in all other spheres, investing also aims to prevent losses, reduce extent of losses, safeguard capital invested and earn profit (not necessarily in that order!). On similar lines, margin of safety is a concept used in stock market investing to pick value stocks, limit losses and enhance gains.

The difference between the intrinsic value of the stock and the transaction price or the current market price(CMP) at which a stock is purchased is called margin of safety.

It inherently, follows the strategy of buying a stock when the market price is below the intrinsic value.

Parallel Comparison

In common terminology, this would be akin to buying a product at a sale or a discount. Besides the monetary savings, one also has the satisfaction of winning a good deal. As per economists, the marginal utility would be enhanced with each additional unit of consumption of the product due to higher savings.

In other words, pay less and derive more value.

In accounting, margin of safety is the level to which sales can dip before a business achieves break-even point. Break-even is a unique scenario, i.e. a point of no loss and no profit.

Often, start-ups or a player operating in a new technology might have to suffer losses for initial years, before the business breaks even and then is able to turn profitable.

Consider the Following Table:

In Crore
Sales Costs Differential amount Status
10 15 -5 Loss
12 12 0 Break even
15 10 5 Profits

Where costs comprise total costs i.e. fixed costs and variable costs

Why does this occur in the first place?

According to behavioral finance, often investors do not take rational decisions in investing- they are either influenced by speculation, herd mentality, irrational exuberance, pessimistic outlook etc.

Thus, often the stock prices being influenced by the force of supply and demand, do not reflect the true intrinsic value of the stock. This is what the fundamental analysts believe.

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Hence, many a time, a stock price is either overvalued or undervalued, rather than being fairly priced. This asymmetry presents an opportunity. One can book profits by buying a stock that is undervalued or trading at a market price lower than its worth.

Against the Tide?

Higher the margin of safety, lower is the potential loss and safer is the stock investment. High MOS does not necessarily mean a profitable investment.

A good company need not necessarily translate into a good investment. Often, a bluechip stock might give just 13% returns p.a, whereas, other average stocks might have generated around 25% returns p.a.

It’s possible one overlooked the margin of safety concept and bought the stock at a CMP with a lower differential from its intrinsic value. Also, just because the price is hammered down, it does not necessarily mean the stock would make a great investment.

Stock Investment decisions are based on probability with a high degree of risk and uncertainty. A good business can be a risky stock and an average performing business can be safe.

The tipping point is when the margin of safety is highest. Thus it makes maximum economic sense to buy the stock at this juncture.

It must be remembered that it depends largely on the risk appetite of the investor and the risk grade of the stock in questions. For example, MOS can be lower in large cap stocks than smallcap stocks.

While a value investor would prefer a MOS of over 50%, an aggressive risk profile investor would be okay with 10-20% MOS.

Consider the following table as a hypothetical example:

Intrinsic value Market Price Margin of safety Strategy
100 120 NA NA
100 100 0 NA
100 85 15% Aggressive
100 50 50% Value investors

Origin

Benjamin Graham, the founder of modern investment theory and a strong proponent of value investing is credited with coining the term Margin of Safety and developing the Graham formula to compute the true value of listed stocks.

He would buy a stock when the trading price was significantly lower than the true value. This was later adopted by Warren Buffet.

Graham derived this concept from fixed income securities and applied it to investing. As part of the loan underwriting process, a bank would consider the income cushion over and above the EMI amount. This is to protect the bank’s financial risk as in case of a reduction in income, there would be sufficient to repay the loan and not default.

Similarly, while investing in bonds, investors would factor in historical pricing and yield aspects, whereby the cash generated would sufficiently cover the interest and fixed charges ‘x’ times.

This past ability to earn in excess of interest requirement constitutes the margin of safety that is counted to protect the investor against loss or discomfiture in the event of some future decline in net income.

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The margin above charges may be stated in other ways – for example, in the percentage by which revenues or profit may decline before the balance after interest disappears – but the underlying idea remains the same- Graham

Instead of retail investors trying to figure out the math of Intrinsic value themselves, Graham presented this formula so as to pick growth stocks.

Graham’s formula (as per the Intelligent Investor)

Intrinsic value = [EPS x (8.5 + 2g)] x [4.4]/Y

Where;

earnings per share is average EPS for the previous 12 months,
8.5 is the P/E base of the stock assuming a zero-growth company,
Expected annual growth rate(g) over seven to ten years

4.4 i.e. multiplier is the interest rate of AAA Corporate Bond in the year 1962 in the US. Graham felt high-grade bonds with returns of 4.4% were the best alternative investment avenue available to investors instead of buying stocks. Thus, the opportunity cost aspect has been considered.

Y is the interest rate of AAA Corporate Bond as on today in the US. This normalizes the time factor.

Many have also attempted to tweak the above formula for the Indian markets context. Besides this, there are different valuation methods to compute the fair value of a stock.

Price Earning method, Book value method, discounted cash flow method (DCF model), dividend discount model, Peer benchmarking, EPS valuation etc.

Expert’s Take

Disadvantages of direct stock purchase plans

Warren Buffet and other leading investors like Seth Klarman, Charlie Munger swear by the margin of safety approach.

Buffet attempts to enter at an attractive price lower than the estimated value. This way he can limit his losses in case of error of judgement or analysis.

Warren Buffet advocates a margin of safety of at least 25%. Buffet’s performance speaks for itself. Between 1965 to 2017, Berkshire Hathaway’s growing market value recorded a whopping 20.9 percent annual return compared to S&P 500’s 9.9 percent.

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Conclusion

Summarizing the above, the investment experts are advocating conservatism by propagating the margin of safety concept. Buying at a discount to the real business value by giving maximum weightage to the worse case scenarios seems to sum up the value investing approach.

The margin of safety can be a useful approach in wealth conservation in the long run, whereby, one does not lose all or most of the money by investing in stocks.

Graham’s own words echoes this sentiment: ‘For indeed, the investor’s chief problem – and even his worst enemy – is likely to be himself… “The fault, dear investor, is not in our stars – and not in our stocks – but in ourselves..’

Happy Investing!

Disclaimer: The views expressed in this post are that of the author and not those of Groww