Margin of Safety

Margin of Safety

Look for safety in the price you pay.

       Marty Whitman

Margin of Safety is probably the three most important words in all of investing, and the one investing concept that has proven itself over time again and again. I read a lot about it in investing books before I got into the market. But reading about something and experiencing it while having your money at risk in the market are two different things. It is the one investing concept that I have found to be truer than everything else that I have read about the markets put together.

So how does one gain a margin of safety? In a word, buy cheap. That means buying things when other people want to sell them, buying things that are unpopular, buying things that are even hated and buying things that people have forgotten about or never knew about. But most of all it means buying something for the less than it is worth.The "the margin of safety" is typically defined as the difference between the intrinsic value of a stock and its market price. The cheaper you can buy a stock relative to its intrinsic value, the bigger your margin of safety. The intrinsic value of a business is equal to all the cash it will generate in the future discounted back to the present time. In other words, buy right (below its market value) and sit tight (extend your holding periods).

When you pay less for a stock than what it is worth it can be a huge psychological advantage. Think about how you would feel if after you bought a stock it dropped in value and kept going down. You might get very discouraged very fast. Buying something with a margin of safety doesn't eliminate the chance of that happening but it certainly improves the probabilities of it not happening and playing the probabilities is what investing in the stock market is all about. Plus knowing that you bought something for less than it is actually worth will help give you the gumption to hold on not allow the market to shake you out of your position.

Probably the best way to learn about this concept is when you ignore it. I bought CBL and RX near the market top in September 2014. They were both high in price and overextended from their base. I took a bath on both of them as they tumbled from their market highs and started an agonizing descent into oblivion. I’m still holding both of them as it has become too late to sell and I still believe in the investing merits in both of these holdings. The problem was I bought them at far too high a price and near a market top. I didn’t have a margin of safety. Your most painful experiences in the market will provide you with your best lessons. The first question I ask myself before I buy anything now is, do I have a margin of safety? In other words take care of the downside (risk) first and the upside (reward) will look after itself.