The concept of the margin of safety is one of the most important concepts of value investing and was first introduced in 1934 in Benjamin Graham's book "Security Analysis". In Graham's second well-known book, The Intelligent Investor, Graham devotes an entire chapter (chapter 20) to the margin of safety and loosely translates it as the "central concept of investing". Practically all well-known and successful value investors have adopted the concept of the margin of safety. As Warren Buffett put it so well:

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„Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1“ Warren Buffett

What you will learn in this article

  • What the margin of safety is
  • Why margin of safety and diversification are closely related
  • How high your margin of safety should be or how you determine the amount of the margin of safety

What is the margin of safety?

Benjamin Graham first describes the margin of safety using the example of a bond, i.e. a fixed-interest security: In order to receive an investment grade rating here, a company does not simply have to have always paid its interest in the past. There are also requirements that state, for example, that the company must regularly earn x times (e.g. as in Graham's book, 5 times) its interest in order for the security to be considered sufficiently high to assume that the company will not get into payment difficulties (investment grade).

Alternatively, company value and debt are often compared: If a company is worth about USD 30 million, e.g. because it has fairly new production facilities, but only has USD 10 million in debt, then we can also speak of a margin of safety. In case of doubt, the debts can most likely be repaid in full by selling the machines.

Of course, uncertainty about a company's future earnings also plays a role here. If we knew with great certainty what the profits would be in the future, then we could live with a much lower margin of safety.

The margin of safety for a share

Benjamin Graham describes the margin of safety for shares in an analogous way. He speaks of a margin of safety when there is an advantageous difference between a company's share price and the investor's estimate of the company's value or the intrinsic value of the share. Advantageous, of course, refers to the constellation in which the share price is below the enterprise value.

There are various ways to estimate the intrinsic value of a share. These range from pure balance sheet analysis, e.g. via price/book value or price/net cash ratios, to profit-based analyses via P/E ratios or DCF valuations.

The margin of safety is therefore there to absorb the negative effects of errors in our calculation or our assessment, or simply the effects of unfavourable market movements.

The probability of a profit is higher for investments with a large safety margin. However, despite the safety margin, losses can still occur with individual stocks. Ultimately, we will always make mistakes and misjudge companies, overlook a risk factor or similar. The safety margin is there to limit the risk of such a loss.

„Investing is built on estimates and uncertainty, a wide margin of safety ensures that the effects of good decisions are not wiped out by errors.“ Warren Buffett

Margin of safety and diversification

Therefore, the margin of safety is closely linked to the concept of diversification. Diversification means nothing other than spreading the risk by not betting on just "one horse". Our risk of loss is reduced if we combine several stocks with a large margin of safety in the portfolio. Benjamin Graham uses the example of a gambler at the roulette table in his book:

Example: A man bets USD 1 on a single number at the roulette table in the casino. If the ball stays on his number, the player gets a profit of USD 35. However, since we have 37 numbers to choose from (38 in the American version of roulette), the probability of a win is only 1/37, i.e. statistically speaking; the ball only stays on each number once every 37 throws. This means that for every win of USD 35, the man loses USD 37 (because he has to bet 37 times USD 1).

In a figurative sense, he has a negative margin of safety. This means that the probability of a loss is higher than that of a win.

Accordingly, diversification does not help here either. If the man diversifies, i.e. bets not only on one but also on several numbers, then the risk of loss will increase even more. In the case of complete diversification, i.e. if the man always bets on all 38 numbers at the same time, he will always lose USD 2 for every USD he bets.

The whole thing looks quite different if the margin of safety is positive. Let us assume that the man now gets USD 39 iin winnings if the ball stays on his number. In this case, the chance of winning increases the more numbers the player bets on at the same time. With complete diversification, the player would then regularly receive a profit of USD 2 per USD wagered.

How many stocks do we need for sufficient diversification? Joel Greenblatt, inventor of the magic formula, presented some interesting statistical evaluations in his book "You can be a Stock Market Genius":

The overall market or a large investment fund with about 50-500 stocks in the portfolio achieved an average return of ~10%. With a probability of 66%, the return was between -8 and +28%.

If the portfolio was reduced to 5 stocks, the average return remained largely unchanged at 10%, only the range became somewhat wider at -11 to +31%.

When the number of shares was subsequently increased to 8, the average return remained unchanged. The range was -10 to 30%.

Margin of Safety

Of course, we do not know which 5 stocks Greenblatt took for his analysis. Besides, the figures refer to the US-Stock Market (although there are also studies, e.g. by Tweedy Browne, which show that actually all regions perform the same). Nevertheless, the result is very interesting. The fluctuations of the individual returns around the average, i.e. the volatility, seem to be quite independent of the number of shares. The values are so similar that the differences are not really statistically significant. This actually means that a portfolio with between 5 and 15 stocks should already be sufficiently diversified.

However, we would have to select these 5 to 15 stocks carefully, firstly to avoid cluster risks (i.e. we should not put 15 commodity companies in our portfolio, as I did at the beginning) and secondly to guarantee a sufficiently high safety margin. That means we would have to spend some time, understand, and assess these 5 to 15 companies very well. We have seen with the roulette example what can happen with a negative safety margin and simultaneous diversification. The return potential should then also be significantly higher than the average 10% for 5-8 randomly selected stocks:

„It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.“ 

Warren Buffett

However, if we do not have the time or leisure for this, then a passive strategy may make more sense. In which we diversify strongly via an ETF or an investment fund (whereby caution: possibly high fees due to issue surcharges and management fees) and achieve the return of the overall market on average (which is already very good and probably better than most alternatives).

The size of the safety margin

I do not think there is a one-fits-all answer to the amount of the safety margin either. In his book, Benjamin Graham talks about a safety margin of one third, i.e. 33%.

But the amount depends very much on the investor or the investment itself: In some cases, it may make sense to pay fair value for a very good company (one that is growing strongly, has high profitability and a sustainable competitive advantage). In other cases, a 50% margin of safety may be appropriate for a high-risk, insolvent company trading well below book or net asset value. In many cases, a 25% margin of safety is applied.

Conclusion

The margin of safety is a concept invented by Benjamin Graham and strongly anchored in value investing. In order to take into account possible negative effects due to market changes or our own errors in share valuation, we apply a further discount to the fair value we have determined for the share, called the margin of safety.

Since there is of course still a risk that even the margin of safety will not be sufficient and that we will not be successful with an investment, we should include between 5 and 15 stocks with a high margin of safety in our portfolio in order to increase our probability of success through diversification. An analysis by Joel Greenblatt, among others, has shown that the volatility, i.e. the risk, does not decrease strongly with the number of stocks in the portfolio and that 5 to 15 stocks already provide sufficient diversification accordingly.

However, a certain amount of time is needed to identify and analyse the good, undervalued companies.

About Alexander Kelm

Alexander Kelm is a passionate value investor and runs the website Wall St. Nerd. Here, the passionate value investor writes in-depth articles on the topic of Value Investing. Value Investing involves analyzing a company's fundamentals and can be characterized by an intense focus on a stock's price, its intrinsic value and the relationship between the two.

Alexander Kelm offers online courses on stock investing.

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