Do you have the experience of stepping in to an elevator which is full, being worried that the overweight alarm will go off? If you are the one who triggered the alert, I believe you will most likely feel embarrassed. But have you wonder why the elevator does not fall even the total weight of the people has it has exceeded the maximum weight allowed according to its label?
Well, this is exactly the concept of margin of safety. The engineers intentionally design structures or machines in such a way to prioritize our safety. For example, for elevators which can withstand the weight of 1300kg, the engineers will label “max. weight = 1000kg” at the elevator. Therefore, we will always be alerted when the total weight is in the danger zone.
The same concept of margin of safety must be applied in your investment. Margin of safety is popularized by Warren Buffett’s mentor, Benjamin Graham. In investing, margin of safety means that value investors only invest in stocks when their share prices are below its intrinsic value. In other words, value investors want to invest in great companies which are undervalued. Here, we will share with you the 2 reasons why you need to have margin of safety in your investment.
1. Risk Reduction
When we have margin of safety in our investment, we allow ourselves to make mistakes and to have a cushion in case an unpredictable event occurs to our stocks.
As quoted by Warren Buffett, “There are 2 rules in investing. Rule number 1, never lose money. Rule number 2, never forget rule number 1.” This quote has been his philosophy in his investing for decades. Does it mean that he did not make any losses? No, he is human as well, even the greatest value investor in the history will make mistake. However, the reasoning behind his quote is not to really not lose money as per say, as we are not able to control that, what he meant is we must be sensible and conservative in investing.
When we make an investing decision to purchase a stock, it is somehow an arrogant act. We believe that there are several reasons that it is good investment. Indirectly, we are telling ourselves that we know more than the seller and thus we make the buying decision. Having humility, we must always have invert thinking on these decisions by having a margin of safety on our valuation of the business.
Even you have identified a wonderful business, overpaying for it will increase your risk exposure. Let say you have identified a great company named, ABC, and you have decided to invest. The share price of company ABC is RM2.00 per share, however, its intrinsic value is only RM1.00. Which means, you are overpaying for the great business. After you invest in company ABC, due to unexpected headwinds, the share price of company ABC dropped 50% and by now, you have lost half of your initial capital. In order for you to recoup your losses, you need to make a 100% return on whatever amount you have left or in other words, you need to achieve 10.41% Compounded Annual Growth Rate (CAGR) for 8 years. Even if company ABC performs well after and net you such returns, you have only reached breakeven point. What if the company did not perform as well? You will have higher risk of losing money.
The problem lies in the price that you pay, not only the company that you have selected. Even a great company can be a bad investment if you pay too much. Thus, we must ensure that we have a margin of safety when investing to protect ourselves.
2. Increase Your Returns
Having margin of safety not only reduces your risk, yet it allows you to boost your investment returns. This may sound contradictory to the most famous quote, “high risk, high return”, as for us to achieve massive returns, we must take on massive amount of risks. Well, that is not true for value investors. We will definitely prefer low risk, high return. When we look at investment opportunities, our first priority is always to ensure that our risk is the lowest. Because when the risks are taken care of, the returns will take care by itself.
When we have margin of safety in our investment, we will then achieve low risk and high return. For example, if we invest in company ABC at RM0.50 per share, but its intrinsic value is RM1.00 per share, the margin of safety would be 50%. Meaning, we have created some buffer or some room for error in our investment.
However, if you look at the potential gain aspect, you have just purchased an asset that is worth RM1.00 at RM0.50. When the asset regained its full value, your potential gain would be 100%. The larger your margin of safety, the lower your risk and yet the higher the potential return.
But…how much margin of safety is required then?
The pre-requisite to apply the concept of margin of safety is only when you understand how to value a company. Margin of safety is applied after you have determined the value or how much the business should be worth or its ‘fair value’. Essentially, for great businesses with strong competitive advantage, we would be willing to pay what its worth. Because a great company will see their value increase over time. For a mediocre company which carries some risks, we would prefer to have some margin of safety.
“It’s far better to buy a great company at fair price, then a fair company at great price”, Warren Buffett.
To have low risk and high return, you must have margin of safety in your investment. Hence, you will need to have patience to wait for the right price. When share price is on the bull run, the anticipation of reward will kick into your emotion even if it does not meet your desired margin of safety. If you do not have the discipline to wait, most of the time you will take on unnecessary risk and jeopardize your returns. That’s the reason value investing is hard to practice.
To be successful in value investing requires much emotional stability than skillset. Most people will feel uncomfortable or even panic when the share price declined. However, if you look at margin safety point of view, when share price decline, you will have even more margin of safety. In layman term, if you get to buy a pair of clothes at 30% discount today, you would not know whether if you will get even more discount the next day. If it does, means you will have much more bargain to buy the clothes.
Disclaimer: All facts and opinions presented are for educational purposes only. This is not a recommendation to buy or to sell. The author involved in the writing of this message has no vested interest in the companies. Please consult a professional for expert financial or other assistance or legal advice.