Safety First!

Benjamin Graham, the author of The Intelligent Investor mentioned “Margin of safety” as the central concept of investment. Why is “Margin of safety” the central thesis of value investing?

What exactly is this “Margin of safety”?

Let us first consider the bulk of the academic literature concerning valuation. Most of them assume perfect world assumptions where your journey from start to end would be a straight line path and the value of the entity in question can be narrowed down to the accuracy of two decimal places.

Well we all know that in the real world, “shit happens”. One’s journey would most definitely not be a bed of roses but rather a roller coaster ride of epic proportions. A practical illustration of the “Margin of safety” concept would be akin to an engineer’s calculation of a safety factor. When building a platform to handle a load of 100kg, an engineer doesn’t build it just to withstand 100kg because some people might choose to “play punk”.  An engineer might build it to hold 200kg or even 300kg corresponding to a safety factor of 2x and 3x respectively.

In essence, incorporating a “Margin of safety” ensures a buffer for uncertainty; providing us with a cushion against errors in our calculations.

How does this concept translate to investing?

Say that based on your assumptions, the intrinsic value of a particular stock was $10/share. If the market is pricing it at $5/share today you would have a margin of safety of 50%. You could be 20% or even 30% off the mark and still be able to consider this an investment. This divergence between price and value is down to the fact that market prices are determined by the consensus of opinions while intrinsic values are derived from a personal perspective (Check out our earlier article); One controllable and the other up to anyone’s best guess.

The probability of making a mistake at some point in your investment lifetime is virtually 100% and some of the times these odds are from an exogenous source. We as individuals cannot dictate the market price.

What we can do is to control the price we pay for it.

This concept can be directly translated over to investing as having a buffer between your intrinsic value and market price. Essentially, market price is negatively correlated with the margin of safety against future uncertainty; the lower the market price, the higher your margin of safety, and vice-versa.

Value In Action

Prudent investors have to understand that not everything is known. Most of the time decisions are based on incomplete information, thus investors would do well to demand a margin of safety to compensate for the uncertainties behind our valuations.

Incorporation of this concept would also allow us to potentially distinguish between an investment and a speculation.

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The information provided is for general information purposes only and is not intended to be any investment or financial advice. All views and opinions articulated in the article were expressed in Cheong Mun Hong’s personal capacity and do not in any way represent those of his employer and other related entities. Cheong Mun Hong doesn’t own shares in any companies mentioned above.

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