margin of safety cover

Three Words That Matters: Margin of Safety

When I worked as a Trainee at Tata Motors, I got to know about the term payload. In easy words, it is simply the load carried by a vehicle. The payload helps the owner to determ­ine how much they can fit in their vehicle and moreover how many trips they have to take to carry a specific load.

During that time, once I was walking with my manager and we were discussing a light truck – Tata 407, which could carry 2.25 tonnes of payload. And we started talking about its payload. My manager told me that most of the commercial vehicles in India are almost always overloaded and easily crosses the prescribed payload. I asked him why do the Tata trucks perform so well then and why it doesn’t break? Obviously, if you overload the truck with twice its capacity, it should snap. And his answer was Margin of safety!!

Before developing any new vehicle, there’s a comprehensive study done on consumer behavior. And the R&D team of Tata knew this Indian behavior of overloading the truck in order to reduce the total number of trips to carry out the goods. And that’s why the load capacity of the Tata trucks are always more than what specified in the manual.

Moreover, here having a safety is a must for Tata trucks as they are known for their strength and the brand image matters a lot while selling vehicles in the automobile segment. They couldn’t afford to get their brand image ruined by not having a margin on their vehicle’s load capacity.

A similar concept of safety is used in the investing world to reduce the risk and maximize the profit. In fact, it is the central concept of value investing.

What is the Margin of Safety?

The margin of safety means purchasing the stock when the market price of the company is significantly below its intrinsic value. Here, the difference in the intrinsic value and your purchase price is called the Margin of Safety (MOS).

The fundamental analysts believe that there is a true (intrinsic) value for all the company which can be found by reading financials of the company. Moreover, they also believe that the stocks do not trade at their true intrinsic value at most of the time because of speculations and other short term market behavior. A stock can be overvalued or undervalued at any moment of time. And that’s why Investors can make good profits by purchasing stocks when they are trading at a discount i.e. below their true value.

The margin of safety helps to safeguard the investments against calculation error, human error, judgment errors or any other unexpected occurrences concerning the market or stocks.

margin of safety chart

The margin of safety plays a significant role while purchasing stocks.

For example, if you think a stock is valued at Rs 100 per share (fairly). Then, there is no harm in giving yourself some benefit of the doubt that you may be wrong with your judgment and calculation. And hence, you should buy that stocks at Rs 70 or Rs 80 instead of Rs 100. Here, the difference in the calculated intrinsic amount and your final purchase price is your margin of safety.

The ideal margin of safety depends on the risk tolerance of an investor. The strict value investors may have a MOS of over 50% to minimize the downside risk. On the other hand, aggressive investors may choose a comfortable MOS of 10–15%. As a rule of thumb, always have a margin of safety of between 10–30% on the intrinsic value of the stock while making your investment decisions.

Moreover, apart from the risk tolerance of the investor, this margin of safety percentage also depends on how risky the investment is. If you are investing in a safe blue chip stock, this margin of safety can be comparatively lower than the MOS on high-growth riskier small-cap stocks.

Methods to find Intrinsic value:

The concept of Margin of safety was poularized by the legendary investor, Benjamin Graham (also known as the father of value investing). He used his ‘Graham formula’ to find the true value of companies, and if the stock was trading way below the intrinsic value, only then he would purchase them. This concept of MOS was later inherited by Warren Buffett, a student of Ben Graham.

There are different tools to find the intrinsic value of a company. While many prefer using PE or Book value to find if the stock is undervalued, one of the most popular method to find the true value of a company is the discounted cash flow. DCF analysis is a method of valuing a company using the concepts of the time value of money. Here, all future cash flows of a company are estimated and discounted by using the cost of capital to find their present values. (Read more here: How to value stocks using DCF Analysis?)

A few other methods to find the intrinsic value of a company is the dividend discount model (DDM), EPS valuation, relative valuation etc.

Also check: Intrinsic value calculators

Closing Thoughts

Having a margin of safety in the investments helps the investors to minimize the downside risk. However, an important point to highlight here is that having a MOS does not guarantee that the investment will always be profitable. Finding the intrinsic value of the company correctly also plays a crucial role here. And therefore, you should spend a significant amount of time valuing the stocks suitably.

Nevertheless, a meaningful discount on the purchase price compared to the intrinsic value can limit your losses and maximize the profits on your investments.

Margin of Safety by Seth Klarman book review

Book Review: Margin of Safety by Seth Klarman

Hi Investors. In this post, we are going to discuss the book review of Margin of safety by Seth Klarman (Originally published in 1991).

About the Author:

Seth Andrew Klarman is an American billionaire investor and hedge fund manager.

He is a graduate of Cornell University and has a business degree from Harvard Business School. Klarman is the founder of The Baupost Group, a Boston-based private investment partnership, that focuses on making value-based investments in the US public markets (founded in 1982). 

In the recent decade, Warren Buffett and his lieutenant Charlie Munger have voiced their support for his investment style and even went on to state that Seth Klarman would be one of their asset managers of choice to manage their personal portfolios. 

Besides, Klarman is also a close follower of the investment philosophy of Benjamin Graham.

Book Review of Margin of safety by Seth Klarman:

margin of safety -seth klaarman

The Margin of Safety by Seth Klarman covers a broad spectrum from providing sound education on the psychology of investing as well as developing the quantitative and qualitative aspects of value investing. It is sometimes said to be the most important book available on value investing after The Intelligent Investor by Benjamin Graham.

The book primarily explores three broad themes for the investor:

  • Firstly the futility of the efficient model hypothesis and the practice of finance professionals of over-relying on their models and estimates.
  • Secondly, it focuses on the concept of risk and the central role it plays in investment success
  • And finally on valuation and market opportunities for the retail investors

Klarman encourages investors to always assess their investments only after first evaluating the risks associated with a particular opportunity and then and only then the potential returns.

In his eyes, the key to a successful track record in investing comes not by achieving higher than average returns but by achieving below than average losses.

This strategy has seemingly worked for him and his investment fund, they have achieved a 19% CAGR for every dollar invested in them (despite maintaining close to 20% cash position in their portfolio for most of the years)

“The avoidance of loss is the surest way to ensure a profitable outcome. Loss avoidance must be the cornerstone of your investment philosophy” – Seth Klarman

The book illustrates this concept through the example of 2 people, say A and B, who invested in the market over a period of 5 years.

Assume A generate returns of 12% for 4 years while B generated only 10%. In the 5th year, due to a market downturn, A’s portfolio witnessed a drop of 10% while B witness a drop of 5%. Because of this significant drop in the down year in A’s portfolio, B ends up having a higher portfolio return in comparison to A.

Also read:

In the book, Klarman espouses that the value investment philosophy is based on three timeless pillars:  a bottoms-up approach to selecting investments one stock at a time, absolute performance orientation that enables one to buy and hold irrespective of short-term relative non-performance and paying attention to the real risk of capital loss, not beta (volatility).

Further, in the book margin of safety by Seth Klarman, the author consistently stresses on the need to focus only on one’s own analysis and to discard the market noise when making an investment decision.

Klarman also discusses the difficulty involved in the art of valuing a business and recommends arriving at a conservative but imprecise range of business value based on 3 or 4 techniques: Net Present Value of Free Cash Flows, Liquidation or Breakup value, and Stock Market Value.

(His book provides practical examples of his philosophy, we encourage our readers to take time to go through his work to improve their knowledge and skill in valuation)

“It would be a serious mistake to think that all the facts that describe a particular investment are or could be known. Even if everything could be known about an investment, the complicating reality is that business values are not carved in stone. If you cannot be certain of value, after all, then how can you be certain that you are buying at a discount? The truth is that you cannot” – Seth Klarman

Klarman closes his masterpiece with tips for retail investors on finding opportunities in the market namely catalysts, market inefficiencies, and institutional constraints, as well as then going on to provide detailed evaluation methods for thrifts and bankruptcy situations.

Also read: 10 Must Read Books For Stock Market Investors.

Bottomline:

In our view, Margin of Safety by Seth Klarman is a must read for all investors of all levels, besides strengthening foundations on the value methodology it also provides insights into how a seasoned investor stays apart from the chaos of the market to generate stable returns. Happy Investing.

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