Value investing is based on the premise that securities or stocks share prices don’t represent the true underlying value of the company.
In many cases the price the stock is trading for it far more than the actual true worth of the company, and sometimes it works the other way too.
As value investors are task is to identify companies that are trading at cheap and undervalued prices relative to the intrinsic value of the business the shares represent.
Remembering at all times that when buying shares we are not doing so on speculation. Rather we are doing the work to discover what the true fair price for shares of a particular company is, and then seeking to buy this stock at a deep discount.
And this is where the margin of safety comes in.
You see if you would like to only make the best investments and limit the downside risk, you must be careful and selective about the stocks you invest in. And you must ensure a margin of safety in case things go wrong.
So considering the context in which I have used the phrase “a margin of safety” you can probably begin to see what it is that I mean. What we are talking about here is ensuring that we are buying a stock at a cheap enough price that there is room for error.
What this means is likely best summed up in an example.
So let’s consider that we thinking about buying Apple stock. We have been using their products for years, we can have done our research and we see that the price of the stock is trading at $150 per share.
After doing some technical analysis in addition to our fundamental look at the company, we come to the conclusion that the fair value of the shares is actually somewhat more like $200 per share.
We also see that the growth of the company is consistent and actually believe it could well reach $250 a share of more within the next twelve to eighteen months.
And so seeing this we consider this to be a discounted price that Apple stock is trading at and a good investment for capital gains in the future.
However we must also factor in that things for the company may not go well. Perhaps a new competitor surfaces and takes a portion of their market share? Maybe the iPhone stops selling so well and revenues come in lower than expected?
These are all factors that can effect the share price and therefore negatively impact your investment.
Which is why we decide to add a margin of safety.
We ask ourselves, if Apple does report lower earnings next year, can we still make a return on investment? Or would that one factor be enough to wipe out any gains we could have made?
If we can consider these different things that could happen and cause the stock price to drop accordingly, and the end result means we still are profitable from our investment, then that is because there is a wide enough margin of safety.
However on the flip side after doing our calculations and seeing that actually if one or two things do go wrong for the company that could see the share price drop below what we are buying it at. Then likely we do not have a good enough margin of safety to go through and make the investment.
As you can see this is highly individual. Two different investors looking at the same stock can reach two completely different conclusions and one invest, while the other look for investments that better suit their investment style.
In many ways this is also to do with risk and how much you are willing to take.
Some investors do not mind taking substantial risks in their investments, or feel that they are diversified enough and hedged in a way that protects their portfolio from risk.
So investing, especially value investing, is very much a holistic practice. We are looking at our investment portfolio in a holistic way.
Instead of looking at single stocks we consider how it fits into our portfolio.
Perhaps we can afford to take more risk and make the investment in Apple in this case, despite there being a small margin of safety. Or maybe we find the risk to our overall portfolio is too great.
Many investors create an overall margin of safety for their investments. So perhaps they invest in three different stocks…
One of them is a very safe stock that pays a good dividend yield. For example AT&T.
The second is an investment in real estate using a REIT (Real Estate Investment Trust) investment. As we know generally the housing market is very good but as we saw back in 2008 even the real estate market can crash.
And then perhaps we invest in a stock like Facebook which could grow and realize a lot of capital gains, or could crash and incur losses to the portfolio.
However because their are three separate baskets of investments in this case, the overall margin of safety of the portfolio as a whole is good.
So there are different ways to apply the margin of safety theory to your investments, both to individual stocks and to your total portfolio.
I suggest that you take this into consideration for every investment you make. Consider the risks, consider the growth, factor in room for error and then invest and sleep well at night.
If you do decide to take a risk on one stock, then hedge that risk by taking another which is likely to be safer, or better yet will perform well if your first stock does not.
For example investing into two competing companies in the same space can at times be a good strategy. If the reason that Apple stock will go down you calculate, is because Samsung is taking a larger market share of the smartphones market, then investing in both companies can be a way of decreasing this risk.
If Samsung does take a larger market share away from Apple it’s stock will go up. Which is good because you are invested in their shares.
If it does not take a larger market share and things continue as normal then likewise you will profit well from your investment in Apple stock.
The most critical factor with considering things like margin of safety is what are the factors that can impact my investment.
When you work out what they are you can then take steps to create a margin through hedging with other stocks and financial instruments, or decide that the investment poses too much risk for your portfolio and move along.
There will always be more investments out there, look for ones that present the greatest upside and the lowest downside. Be relentless in your search and consider all your options.
Do this and the margin of safety will take care of itself.