If you were to distill the secret of sound investment into three words, we venture the motto, Margin of Safety. -- Benjamin Graham
What is 'Margin of Safety'?
It is the difference between the Intrinsic Value* and the current Market Price of the security.
(*) Intrinsic Value is a company's value as appraised by the investor. This valuation process is every investor's responsibility.
Why is Margin of Safety Important?
Theoretically, the further a stock's market price lies below its intrinsic value, the greater should be its resilience in down markets. A margin of safety should provide an investor some reasonable protection - in terms of preserving one's invested capital - when things get rough.
According to Ben Graham, protection of one's investment principal is paramount to any objective of achieving a profit. As a prudent investor, a margin of safety is therefore, both a desirable and necessary component to any sound investment program.
Ben Graham and Margin of Safety:
One should understand that Ben Graham was investing during and after the "Stock Market Crash of 1929" and the subsequent "Great Depression" of the 1930's. And it was in this severe financial and economic environment that necessity drove Graham to invent a way to achieve some added safety for the capital he risked in the stock market.
Graham used diversification and his new concept of margin of Safety and bought dozens of "bargain" stocks selling below the internal asset values he calculated. Graham was not buying "wonderful companies." Graham was simply trying to obtain a fair return on the difference between his derived internal asset value and the discounted stock price available in the marketplace.
Graham knew there was a fair probability that the market price might never fully reflect the entire value gap he found, or the business might continue to degrade and eat up all or more of his profit potential. This is why Graham required a substantial margin of safety - one that would give him sufficient investment protection and enable him an opportunity for a fair return; or at least his original investment back.
Note: Graham was not buying many growth companies. Therefore, Graham faced the Realization of Value problem - namely, the longer it took the market to close the 'value gap', the lower his ultimate rate of return. And that rate of return dropped quickly!
Graham finds a company selling 40% (Margin of Safety) and buys the common stock. Then he sits back and waits for the market to pick up on the 'value gap' and raise the price. If the price moves back up and closes the 40% gap in:
3 mos. his annualized rate of return is 160%
6 mos. his annualized rate of return is 80%
1 yr. his annualized rate of return is 40%
2 yr. his annualized compounded rate of return is 18.3%
3 yr. his annualized compounded rate of return is 11.9%
4 yr. his annualized compounded rate of return is 8.8%
If after 1 year the marketplace only returns 40% of Graham's calculated margin of safety, his final rate of return would be 16%! (0.4 ROR x 0.4 Value Gap = 0.16 ROI actual)
Warren Buffett, Charlie Munger and Margin of Safety:
Warren Buffett and Charlie Munger do not buy companies like Ben Graham. Buffett and Munger typically buy GAARP (Growth At A Reasonable Price) companies. Buffett loves to wait and load up on 'wonderful companies' that Mr. Market has irrationally oversold or overlooked.
Buffett says his approach in choosing a great company stock is "very much profiting from lack of change. That's the business (Charlie and I) like. I put weight on certainty. If you do that the whole idea of a 'risk-factor' doesn't make sense to me. The definition of a great company is one that will be great for 25-30 years."
The point of bringing in Buffett and Munger into this discussion is to demonstrate how Buffett and Munger overcame the Realization of Value problem incurred by Graham's style of investing. They did this by bringing growth into their investment selection process. Growth allowed Buffett and Munger to not only purchase a company stock at a smaller margin of safety, but it also provided a long-term upside possibility beyond the realization of value return; namely - future value creation from growth of an ongoing business = stock price appreciation.
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