Value Investing Part III: Margin of Safety

Be sure to read Part I and Part II of this series.

Warren Buffett calls Margin of Safety "the three most important words in investing."

Margin of Safety is a concept originally described by Benjamin Graham in "The Intelligent Investor" (This is a must read for any serious investor. Follow the link to Amazon and buy it NOW).

Margin of Safety is an integral part of Graham's definition of Investment. It increases the probability that we will achieve "safety of prinicipal and an adequate return." Without a Margin of Safety we are not investing, we are speculating.

The process of determining the value of a stock is imprecise. It is dependent upon estimates and projections of future events. There is a high probability that even the greatest investor will make mistakes when valuing a company. To compensate for errors in our estimate of value we must purchase stocks for less than the value. For example, if I think XYZ Corp. has a value of $20 per share I wouldn't want to buy it for $20 a share. Sure, if my value estimate is spot on, I probably won't get hurt by paying $20. But the chance that my value estimate is absolutely correct is nearly zilch. As a result, I want to buy XYZ Corp. for less than $20.

How much less? The answer is completely subjective. It depends on how comfortable you are with your estimate of value and the risks the company faces that could impair its value. If you are confident that your value estimate is highly reliable and there are few risks that could impair value, then you might be willing to buy at $15. Conversely, if the risks of impairment are high you might require a price of $10 to trigger a purchase of shares. You should think of Margin of Safety as a concept rather than a specific number. The Margin required in any specific situation depends on the circumstances surrounding that situation.

Mohnish Pabrai, in The Dhandho Investor, describes Margin of Safety as buying $1 bills for $0.50. A value investor searches the market for situations where he can buy a stock for half of what it is worth and sells it when the price is at or near value. In Pabrai's words, buy a $1 bill for $0.50 and sell it when the price recovers to $1; an extremely profitable proposition. The Dhandho Investor is another book on my 'Must Read' list. Follow the link and buy it now.

What should be clear by now is the relationship between Margin of Safety and Graham's definition of investment. A larger Margin of Safety lowers our probability of permanently losing money and increases our probability of earning an adequate return. Said another way, Margin of Safety decreases risk and increases expected return.

This concept runs counter to what our emotions would have us do. When stock prices are going down, fear sets in and we want to sell. But if you believe in the Margin of Safety concept, declining stock prices is exactly when you should be buying. Because when prices are declining the Margin of Safety is going up.

Value investing is contrarian by nature. Prices go down when there are more people willing to sell then there are people willing to buy. Therefore you have to be able to operate against conventional wisdom. Warren Buffett says it best, "Be greedy when others are fearful, and fearful when others are greedy." To be a successful value investor you must be able to think independently and trust your judgement. If the prices of your stocks are going down and you are questioning the wisdom of your purchases take solice in the words of Ben Graham, "You are neither right nor wrong because the crowd agrees with you. You are right because your facts and reasoning are right."