â€œIn the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, â€˜This too will passâ€™. Confronted with a like challenge to distil the secret of sound investment into three words, we venture the motto, Margin of Safety”. â€“ Ben Graham
As it is impossible for a common man to predict the market movement as there is only one Nostradamus we know of. So what becomes very important is – not to predict the market however to be ready for it. This margin of safety is the tool to build the arc for bad weather like Noah. Margin of safety are the three golden words which counts in the ultimate battle of investment. It does not matter an investor is going with Mr. Market or against him; he should have margin of safety. Let us explore why the â€˜Aristotleâ€™ of wealth creation world advocates so?
Why it is important?
Value investors seek a margin of safety, allowing room for imprecision, bad luck, or analytical error in order to avoid sizable losses over time. A margin of safety is necessary because:
- Valuation is an imprecise art
- Future is unpredictable, and
- Investors are human and do make mistakes
First thing first: Before we get ready for the battle with Mr. Market, we should understand which side we are in. In his book-â€œMargin of safetyâ€ Seth Klarman have written it quite spectacularly:
- â€œIf you look to Mr. Market as a creator of investment opportunities, you have the makings of a value investor.â€
- â€œIf you insist on looking to Mr. Market for investment guidance, however, you are probably best advised to hire someone else to manage your money.â€
Margin of safety is not a hard-core finance concept; it is more relevant in day to day life also. Let us say: You are readying up for an important meeting at 9:00 AM and usually you leave for the office at 8:00AM.But today you decide to leave for the office at 7:45 AM, because you donâ€™t know the traffic (â€œMr. Marketâ€).So this 15 Minute is your margin of safety.
Similarly, if youâ€™re long on a stock and you value it at Rs 10 a piece, and current market price is exactly Rs 10. Buying makes complete sense to you. Stop there. Wait for the price to fall to letâ€™s say Rs 7.5 or Rs 8 whatever and then BUY. This gives you a 20-25% margin of safety. The plain and simple mantra is: Buy a stock at discount to its intrinsic value. In other words buy at bargain price. But that doesn’t mean it’s necessary to do an actual intrinsic value calculation and then slap on some percentage discount to that value.
According to Graham, “The margin of safety is always dependent on the price paid. For any security, it will be large at one price, small at some higher price, non-existent at some still higher price.” That is pretty evident from the illustration below:
How does veterans investors calculate margin of safety?
Benjamin Graham has dictated a rule which clearly demonstrate his approach to applying Margin of Safety in investment decisions. The rule is: Buy a stock for a price that is less than two-thirds of its net assets. An important thing to note is that Graham gave no weight to a companyâ€™s plant, property, and equipment. Furthermore, he deducted all the companyâ€™s short- and long-term liabilities. What remained would be the net current assets. If the stock price was below this per share value, Graham reasoned that a margin of safety existed and a purchase was warranted.
Buffett has said that with something like Union Street Railway – bought back in the 1950s – he saw the margin of safety was that it was selling for much, much less than its net cash. For Coca-Cola the margin of safety was the confidence he had in future drinking habits around the world.
He is one of the ace wealth wizards of India. He has famously said about Force Motors that he bought the stock in spite of so much written/talked about the companyâ€™s management not being frugal by buying aircrafts etc. In his words â€œ..So I found that was not enough reason to ignore this company when it was priced at Rs 500-600 crore of market cap and had a beautiful balance sheet. The balance sheet size reserves are more than Rs 1000 crore and the company was available at half the price.â€ That is the margin of safety for him. The current market cap of Force Motors is approximately Rs 3700 Crs : A clear 6 bagger in less than 1.5 years.
(P.S.: Traffic is a perfect metaphor for Mr. Market. Your chances of survival and escaping an accident do not merely depend on how good you are a driver but also on how bad a driver is driving in your nearby lane.
Related links you will like:
Making Money when interest rates are falling
Importance of relative valuation