What is Margin of Safety?
Published On: July 9, 2021
Written by: Ben Atwater and Matt Malick
Investors generally use the phrase “margin of safety” to describe Benjamin Graham’s philosophy of purchasing a stock with a market price lower than its intrinsic value. In other words, a margin of safety is the intrinsic value of an investment minus its current price.
When investors attempt to determine an intrinsic value, they look at objective measures like cash on hand, the value of other company assets, etc. They also look at models like discounted future cash flow, dividend discount, etc.
When working with models, analysts assign specific mathematical values to their equation. Although the equations themselves are objective, the inputs are nonetheless subjective. After all, who really knows the long-term rate of growth of a company or whether it can sustain consistent increases to its dividend over the coming decade?
Additionally, analysts need to consider other subjective measures like the value of the company’s brand, the quality and depth of its management team and the prospects for its products and services.
Regardless of how one calculates an intrinsic value, it is hard to imagine given the strength of the current bull market that too many stocks today sell for less than their intrinsic value. In this context, then, margin of safety is a relative term.
In today’s world of lofty stock valuations, we must settle for companies that have a measurable value that would limit their downside in a correction. And, at a very basic level, have the wherewithal to survive as going concerns amidst even the most challenging of times.
Such companies must have a long track record of profitability; an ability to pay a dividend and a history of increasing that dividend over time; show a commitment to and a history of repurchasing shares; generate free cash flow over time; and sell for a multiple (like price-to-earnings) below the market averages.
In the spirit of Ben Graham, we would describe owning these kinds of stocks as the traditional foundation of margin of safety investing. We are going to attempt to further define margin of safety beyond the individual stock context. We will do so in a portfolio context.
Laddering high quality bonds (owning a series of bonds that mature annually and in subsequent years) as part of a portfolio is perhaps the best way to build a margin of safety. When you have an allocation to safe assets it will reduce your portfolio’s volatility, but it will also decrease your portfolio’s returns over the long-term. During a bull market using bonds to create a margin of safety can make you feel like you are missing an opportunity, but when a bear market arrives you will wish you had more bonds.
Risk is commensurate with return. If you want to maximize return, you will invest exclusively in equities and other risky assets and leverage the portfolio (use borrowed money to buy even more stocks). But this is a nonstarter for most people, and a losing proposition for most others.
People often want to maximize returns, but they do not want the market to literally wipe them out, as can happen with leverage (or in building speculative portfolios with stocks that may have performed well in a cycle but have no fundamentals). Stretching for return during a bull market can lead people to forget the risk they are taking and set themselves up for ruin.
Behaviorally, most investors need a margin of safety in their portfolio to reduce volatility and be able to stay the course in a bear market. Staying the course is the only way for investors to capture the historical returns of markets.
Understanding what kind of margin of safety is necessary to keep you in the market – no matter what happens – is something we focus on for every client. It is typically the most crucial decision we make as investment advisors. Goal-based investing needs to inform your margin of safety.
In other words, why are you investing? What kind of return do you need to meet your goals versus simply having more money? Do you really understand how you will react when your account value plummets during the next tech bubble, financial crisis, pandemic or whatever else will happen?
How much pain can you really handle to capture long-term market-like returns? A 50% loss, a 25% loss, losing $1,000,000, losing $500,000?
How do future savings and / or liquidity events inform your risk level? What about your other risk assets like small businesses, rental property, company stock, etc.?
We must be continuously aware of our margin of safety and customize that margin of safety based on our unique goals and circumstances, even when it seems like risky assets are the only place to invest.