A MARGIN OF SAFETY

 

When investing in shares, your primary goal is to make money, followed by not losing money. One way you can achieve this is by applying a comfortable margin of safety.

 

The most successful investing minds such as Warren Buffet, Benjamin Graham or Seth Klarman understand the value of having a margin of safety when investing. But what does this mean?

 

1.      Why You Need A Margin of Safety

 

‘If you're driving a truck across a bridge that says it holds 10,000 pounds and you've got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay, but if it's over the Grand Canyon, you may feel you want a little larger margin of safety...’ 

1997 Berkshire Hathaway Annual Meeting

 

Applying a margin of safety to your investments is about paying less for the share price than the intrinsic value of the business.

 

The lower the share price in relation to the value of the business, the greater defence you are likely to have against market downturns, recession and panic.

 

2.      Seth Klarman Said It Best

 

In 1991 Seth Klarman wrote a book titled ‘A Margin of Safety – Risk Averse Value Investing Strategies For The Thoughtful Investor’.

 

In that work Klarman asserts the aim to buy shares ‘at a significant discount to underlying business value, and giving preference to tangible assets over intangibles’. Klarman argued that cash and tangible items like property take precedence over intangibles like goodwill. Good investment advice.

 

If you were to lend someone money and you had the option to secure it against his new sports-car, or his word, which would you choose?

 

3.      Three Words Matter. Value, Value, Value.

 

Don’t rush in. In investing it is better to be a tortoise than a hare. Your research can afford you a margin of safety against risk.

 

Banjamin Graham states early in The Intelligence Investor that ‘If you were to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY’.

 

4.      What’s The Worst That Could Happen?

 

Always consider your worst case scenario. Consider investing in BP during its current crisis. How bad could it reasonably get?

 

If you come to the conclusion that BP could go bankrupt then you would avoid the investment. If your conclusion was that the current price for BP is irrationally low and that the worst outcome is less severe than the market suggests, you may consider yourself to have a margin of safety.

 

To conclude we return to the start and our aim to make money. If you can combine the application of a margin of safety with finding a great company temporarily under-valued, you will be off to a great start.

 

‘Take the course opposite to custom and you will almost always do well.’

Jean Jacques Rousseau (1712-1778) Swiss political philosopher and essayist.

 

Jamie E Smith

 

This content was provided by one of our users, Jamie