In general, people do not like surprises. More precisely, people do not like adverse surprises. Because investors are assumed to be more averse to losing money than gaining it, modern investment theory views the volatility of an asset, as measured by its beta, as the main component of risk. The theory implies that investors should pay less for an asset with a higher beta.
Introduced by the father of value investing, Benjamin Graham, and notably implemented by Warren Buffett, margin of safety was presented as a different view of risk and how to protect against it. Graham's concept is not new. He first presented his investing style with David Dodd in 1934's "Security Analysis" and later with his more accessible book, "The Intelligent Investor", which was first published in 1949.
|Example - Finding A Company\'s Net-Net|
ABC Company has the following balance sheet and market capitalization:
Cash Equivalents $50
Accounts Receivable (A/R) $100
Total Liabilities $300
Share Price $62.50
Cash and cash equivalents are good to go, we have $300 there. Next, we turn to A/R, some of which will not be paid. Usually we have a net A/R number on the balance sheet, indicating the amount of receivables the company expects to recover. If we have it, this net number is based on the company's history of collecting receivables, and is a good indicator, but we would still discount it a little for added safety.
SEE: Volatility's Impact On Market Returns
We end up with marked down current assets of $425 ($300 + $75 + $50), and total liabilities of $300. This net-net is worth $125 ($425 - $300), not even accounting for any real estate or other long-term assets the company might have. With the company selling at only $62.50 in the market, this is a net-net with a 50% margin of safety. Paying half of a company's net-net value was Graham's goal, and at most, he would pay two-thirds of a company's net-net value, for a 33% margin of safety. In our example, we have a 50% buffer between the market value of the company and our conservative valuation of the company's current assets. By only buying at a steep discount to our valuation, this margin of safety provides its own built-in measure against the risk of mistakes in our calculations.
This process of investing did not guarantee success, but with research and hard work, finding one of these scenarios was about as close to a sure thing as you could get. A lot has changed, and Graham's net-nets have essentially disappeared in the modern market. With the quick and widespread dissemination of information, markets have become somewhat more efficient.
|Example - Taking the Value of Long-Term Assets Into Account|
In the ABC example, we gave absolutely no value to the company\'s long term assets. Let\'s return to the example and suppose that that the company\'s share price is now at $200. We calculated its net-net worth at $125, so according to that it would not be a good value, but we note that ABC also has the following assets on its books:
Plant, Property, & Equipment $200
Long-Term Bonds $100
We notice from some research that the plants on the company's balance sheet have likely appreciated because property values have gone up in that area. However, we will remain very conservative in this example and still value it at $200. Next, with the company's long-term bonds, we may worry about the market value if the bonds need to be sold quickly. We will only accept 75% of the value, and value the bonds at $75 ($100 x 0.75). We end up with an asset value of $400 (net-net worth of $125 + $200 + $75). Again, we can buy the stock of this company with a 50% margin of safety at its current market price of $200.
Now looking strictly at beta, let's say ABC had a beta of 1.5. After all of our work, we decide to go to bed and buy tomorrow. However, the next day, "Mr. Market" decides to take the price of ABC down to $150, while the rest of the market stays pretty flat. This sharp 25% decline in ABC stock makes it riskier according to beta.
The concept of margin of safety as practiced by Warren Buffett is not that complicated. These are fairly simple ideas, and should teach us all not to rely simply on volatility as a judge of risk. Many common theories of risk make volatility out to be a bad thing, and if a stock's sea becomes choppy, some investors may sail for calmer waters. But take a cue from Warren Buffett. He, and other value investors, get excited in volatile and down markets. If you invest carefully, and with an adequate margin of safety, Mr. Market's mood swings can lead to great opportunities.
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