Margin of Safety
Margin of Safety is a notion coined by Benjamin Graham in The Intelligent Investor to reduce risk in an investment portfolio. Since errors are unavoidable and much of what happens in the business environment is beyond the investor's control, it's necessary to provide a cushion against the inevitable negative events that transpire.
We will briefly cover the following components to Margin of Safety:
- Price vs. Value
- Earnings Power
- Diversification
- Coverage
Price vs. Value
In The Intelligent Investor, Graham explains that it's important to distinguish between price and value. By purchasing securities when their market price is significantly below their intrinsic value, investors create a buffer against potential losses. Value is derived from an analysis that looks into a company's assets, earnings, dividends, and growth prospects. The market price, on the other hand, is set by Mr. Market and is driven by sentiment, especially in the short run. Over time, the market price should mean revert towards its true value.
Earnings Power
Earnings power, as described by Graham, is the ability of a company to sustain and grow earnings over time. If research reveals that a company does have earnings power, it's also important to compare the earnings yield (inverse of P/E) to bond rates. The spread between the rates would be a factor in Margin of Safety. Warren Buffet has described interest rates as being like gravity.
Since an interest rate of an asset like a 10-year treasury bond is considered risk-free (of default), the earnings yield should be considerably higher than the risk-free rate. When interest rates rise or fall, this has an impact on the valuations of other assets.
Diversification
Graham describes diversification as being a companion to Margin of Safety. Because even the best process has the possibility of producing a negative result, diversification can help reduce the impact of a single bad stock pick. Over the longer run, focusing on good processes (over outcomes) will even everything out over time.
Coverage
Coverage includes the company being able to adequately pay its interest, dividends, and stock buybacks. This includes difficult times as well as normal times. Too much debt results in the company being vulnerable to changes in interest rates and slumps in the overall economy. Coverage problems can be compounded when the company is borrowing the money to make the dividend payments and/or buyback stock.
Applying Margin of Safety with Growth Stocks
When investing in growth stocks (which is the focus of Valuations.cloud), the expectation is that earnings and cash flows will be much greater in the future than in the past. This requires the investor to estimate future growth. Graham states that projections should be conservatively made and have a satisfactory level of margin. This could entail producing a range of outcomes that include optimistic and less than optimistic results to derive lower and upper boundaries that produce the range.
Chapter 20 of The Intelligent Investor is highly recommended reading for a more in-depth illustration of Margin of Safety.