What is an appropriate margin of safety?

Even among value investors, there is ongoing disagreement concerning the appropriate margin of safety.



Some highly successful investors increasingly recognize the value of intangible assets.

Some highly successful investors, including Buffett, have come increasingly to recognize the value of intangible assets - broadcast licenses or soft-drink formulas, for example - which have a history of growing in value without any investment being required to maintain them.  Virtually all cash flow generated is free cash flow.



The problem with intangible assets, is that they hold little or no margin of safety. 

The most valuable assets of Dr Pepper/Seven-Up, Inc., by way of example, are the formulas that give those soft drinks their distinctive flavours.  It is these intangible assets that cause Dr Pepper/Seven-Up, Inc., to be valued at a high multiple of tangible book value.  If something goes wrong - tastes change or a competitor makes inroads - the margin of safety is quite low.



Tangible assets, by contrast, are more precisely valued and therefore provide investors with greater protection from loss.  

Tangible assets usually have value in alternate uses, thereby providing a margin of safety.  If a chain of retail stores becomes unprofitable, for example, the inventories can be liquidated, receivables collected, leases transferred, and real estate sold.  If consumers lose their taste for Dr Pepper, by contrast, tangible assets will not meaningfully cushion investors' losses.

Can You Sum Up Your Investing Philosophy in 10 Words?

By Jason Zweig

Associated Press

Abraham Lincoln in 1858

In a speech to the Wisconsin State Agricultural Society in Milwaukee on Sept. 30, 1859, Abraham Lincoln told this anecdote:

“It is said an Eastern monarch once charged his wise men to invent him a sentence, to be ever in view, and which should be true and appropriate in all times and situations. They presented him the words: ‘And this, too, shall pass away.’ How much it expresses! How chastening in the hour of pride!—how consoling in the depths of affliction! ‘And this, too, shall pass away.’  And yet let us hope it is not quite true.”

I was recently reminded of Lincoln’s wonderful speech when someone asked me if I could summarize my investing beliefs in no more than 10 words. I laughed and said, “Of course not!”

But right afterward, I realized to my surprise that I could. I banged this out almost instantly:

Anything is possible, and the unexpected is inevitable. Proceed accordingly.

I asked some leading investors and financial thinkers for their own contributions.  Here are a few:

Determine value.  Then buy low, sell high.  ;-)

—David Herro, chief investment officer for international equities, Harris Associates, and manager of Oakmark International Fund

If everybody wants it, I don’t. Avoid crowds.

—Gus Sauter, chief investment officer, the Vanguard Group

Other people are smarter than you think they are.  Index.

—Laurence B. Siegel, research director, Research Foundation of the CFA Institute

Risk means more things can happen than will happen.

—Elroy Dimson, expert on long-term stock returns, London Business School, and co-author, “Triumph of the Optimists”

Invest for the long term and ignore interim aggravation.

– Charles D. Ellis, director, Greenwich Associates, and author, “Winning the Loser’s Game”

100% of business value depends on the future.

—Bill Miller, chairman and chief investment officer, Legg Mason Capital Management

Plan for the worst. Hope for the best.

—Robert Rodriguez, managing partner, First Pacific Advisors

Control what you can: your savings rate, costs, and taxes.

– Don Phillips, president, fund research, Morningstar

In the end, you cannot take your investments with you.

– Meir Statman, finance professor, Santa Clara University, and author, “What Investors Really Want”

The less portfolio management costs, the more you earn.

—Burton Malkiel, professor of economics emeritus, Princeton University, and author of “A Random Walk on Wall Street”

Own competently managed, competitively advantaged businesses at discounted prices.

—O. Mason Hawkins, chairman and chief executive officer, Southeastern Asset Management

Do the math. Expect catastrophes. Whatever happens, stay the course.

– William J. Bernstein, Efficient Frontier Advisors, and author, “The Four Pillars of Investing”

Fallible, emotional people determine price; cold, hard cash determines value.

—Christopher C. Davis, chairman, Davis Advisors and co-manager, Davis New York Venture Fund

New submissions are also coming in:

Save. Invest long-term. Compounding returns builds. Compounding costs destroys. Courage!

–John C. Bogle, founder, the Vanguard Group

Are you smarter than the average professional investor? Probably not.

– William F. Sharpe, emeritus professor of finance, Stanford University, and Nobel Laureate in economics

Finally, it’s worth remembering that the great investing analyst Benjamin Graham engaged in a similar exercise (also evoking Lincoln’s tale) but came in seven words under our maximum:

In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, ‘This too will pass.” Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.”

—Benjamin Graham, “The Intelligent Investor,” Chapter 20.

In the spirit of Lincoln’s classic anecdote, can you sum up your investing philosophy in no more than 10 words that you believe will be “true and appropriate in all times and situations”?

http://blogs.wsj.com/totalreturn/2012/01/27/can-you-sum-up-your-investing-philosophy-in-10-words/?mod=WSJBlog&mod=totalreturn

Margin of Safety Concept in The Business Venture of Making Profits from Security Purchases and Sales

To Sum Up

Investment is most intelligent when it is most businesslike. It is amazing to see how many capable businessmen try to operate in Wall Street with complete disregard of all the sound principles through which they have gained success in their own undertakings.

Yet every corporate security may best be viewed, in the first instance, as an ownership interest in, or a claim against, a specific business enterprise. And if a person sets out to make profits from security purchases and sales, he is embarking on a business venture of his own, which must be run in accordance with accepted business principles if it is to have a chance of success.

The first and most obvious of these principles is, “Know what you are doing—know your business.” For the investor this means: Do not try to make “business profits” out of securities—that is, returns in excess of normal interest and dividend income—unless you know as much about security values as you would need to know about the value of merchandise that you proposed to manufacture or deal in.

A second business principle: “Do not let anyone else run your business, unless (1) you can supervise his performance with adequate care and comprehension or (2) you have unusually strong reasons for placing implicit confidence in his integrity and ability.” For the investor this rule should determine the conditions under which he will permit someone else to decide what is done with his money.

A third business principle: “Do not enter upon an operation— that is, manufacturing or trading in an item—unless a reliable calculation shows that it has a fair chance to yield a reasonable profit.  In particular, keep away from ventures in which you have little to gain and much to lose.” For the enterprising investor this means that his operations for profit should be based not on optimism but on arithmetic. For every investor it means that when he limits his return to a small figure—as formerly, at least, in a conventional bond or preferred stock—he must demand convincing evidence that he is not risking a substantial part of his principal.

A fourth business rule is more positive: “Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it—even though others may hesitate or differ.” (You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.) Similarly, in the world of securities, courage becomes the supreme virtue after adequate knowledge and a tested judgment are at hand.

Fortunately for the typical investor, it is by no means necessary for his success that he bring these qualities to bear upon his program—provided he limits his ambition to his capacity and confines his activities within the safe and narrow path of standard, defensive investment. To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks.


Ref:  The Intelligent Investor by Benjamin Graham

CHAPTER 20  “Margin of Safety” as the Central Concept of Investment

Also read:

• Margin of Safety Concept in The Business Venture of Buying and Selling Stocks
• Margin of Safety Concept in Conventional and Unconventional Investments
• Margin of Safety Concept in Speculation and Investment
• Margin of Safety Concept in Diversification
• Margin of Safety Concept in Undervalued or Bargain Stockss
• Margin of Safety Concept in Growth Stocks
• Margin of Safety in Good-Quality and Low-Quality Stocks.
• Margin of Safety Concept in Common Stocks
• Margin of Safety Concept in Bonds and Preferred Stocks

When to Buy Any Stock: Consider Margin of Safety

Having computed intrinsic value of a stock, we know that a stock should be purchased only if the market price is below the stock's intrinsic value.

"How MUCH lower should the price be relative to the intrinsic value?"

Think of the margin of safety for any stock as the difference between a stock's intrinsic value and its market price.

If you buy a stock at its intrinsic value, you will have no margin of safety.  

• If everything goes as you assume in your calculations, you will earn an annual rate of return equivalent to the discount rate assumed.
• For example, if you assume a discount rate of 7 percent and purchase the stock at intrinsic value, your annual rate of return will be 7 percent.  

If the same stock is purchased at 25 percent below the intrinsic value, 

• the calculations show that the rate of return will be about 10 percent per year.  

And if the stock is at half the intrinsic value, 

• the rate of return will be about 15 percent.  

So it seems logical that you should buy a stock with a large margin of safety.

An alternate way of thinking about looking for a large margin of safety is to require a large discount rate.

Related posts:

Intelligent Investor Chapter 20: Margin of Safety as the Central Concept of Investment

The Intelligent Investor: “Margin of Safety” as the Central Concept of Investment

Value Investing: Provide a Margin of Safety

Everything Buffett Needs to Know, He Learned Right Here

****Price to Earnings Growth Ratio (PEG) Explanation

A great company can be a lousy investment. Always incorporate a margin of safety.

Buying when the price is right.

Value Investing: Provide a Margin of Safety

The idea of buying a company at a bargain price to achieve a margin of safety, provides a buffer if business events don't turn out exactly as predicted (and they won't).

The value investing style calls for building in margins of safety by buying at a reasonable price.

The style also suggests finding margins of safety within the business itself, for instance:

• so called "moats" or competitive advantages that differentiate the business from its competitors
• a large cash hoard, or,
• the absence of debt.

These offer a financial margin of safety.