myinvestingnotes.blogspot.my (Bullbear Buffett Stock Investing Notes): July 2011

The margin of safety

Benjamin GrahamOctober 2nd, 2008

The genius investor Warren Buffett once called it “buying one dollar for 70 cent”, the Margin of safety which was developed by the brilliant man Benjamin Graham in 1934. The precept of the margin of safety is very logic and works as follows.

Most people believe that the stock markets are rational, so that the stock-rate always reflects the actual value of a company. But that´s not true , you can prove that very easily. We you look back to the big ups and downs in times of a market crash. It´s definitely not logical that a company looses 60 % of its value and wins 120 % back in a short period of 2 years while the earnings constantly grow by 5 %. So we can conclude that the markets are irrational because sometimes the people become too afraid and sell very cheap stocks and sometimes they are just too optimistic and buy too expensive stocks. It´s not very intelligent but most people like to follow the herd.

But now, let´s get back to the margin of safety. If you know that the stock markets are irrational then why don´t make profit of it? First you look for very unpopular “cheap” stocks, the market capitalisation has to be far below the intrinsic value. That could be companies in trouble, after they reported bad news or complete industries with problems.

Now you calculate the value of the company in order to do that you can use different methods. 1. The Earning-capacity value 2. The Net asset value3. The liquidation value. So for example, if you calculated that the intrinsic value of a company has the value of 100 Million USD, but the market capitalisation just lies at 70 Million USD, you get a margin of safety of 30% or 30 Million USD. You buy this stock and when the market capitalisation achieves the intrinsic value again you sell it.

Note: The margin of safety has not to be exactly 30 percent, but the higher it is the safer is the investment.