Margin of Safety – the Clock’s Ticking

4 minutes reading time

 

It is our argument that a sufficiently low price can turn a security of mediocre quality in to a sound investment opportunity – provided that the buyer is informed and experienced and that he practices adequate diversification. For, if the price is low enough to create a substantial margin of safety, the security thereby meets our criterion for investment. Benjamin Graham, The Intelligent Investor

There is no concept more fundamental to value investing than the concept of the margin of safety. Yes, “Mr Market” and the importance of remembering that stocks are really companies and not just numbers on a screen are also important. But its the ability to buy assets for less than their worth, i.e. a margin of safety, that drives value investing’s performance.

As the quote by Graham highlights, it’s the price that matters. Buy a stock at a deep discount to your estimate of the intrinsic value, and you do two things:

  1. Create an opportunity to earn an above-market return
  2. Build in a buffer against inevitable mistakes

Investing is all about the future and the future is unknowable. It requires making decisions in the face of uncertainty and with incomplete information. Logically, it makes sense for investors to insist on a margin of safety.

The idea’s simple. An investor estimates that the intrinsic value of a company’s stock is $100. The company’s share price is $50. Thus, there is a 50% margin of safety. If the stock reaches its intrinsic value, our investor makes a 100% profit.

OK, sounds easy. All we have to do is find the proverbial “dollar selling for 50 cents” right? Not exactly. The gap between price and intrinsic value, the margin of safety has to close within a reasonable period of time.

MoS Calculation

The table above illustrates the impact on time on the margin of safety. Suppose an investor pays $50 for a stock with an intrinsic value of $100. The stock reaches its intrinsic value after a year and they earn a 100% profit. Let’s assume that our investor is in the highest US tax bracket of 39.6% .They hold the stock for just over 12-months and the profit is treated as a long-term gain and is taxed at 20%.

The after-tax return is 80%. The historical long-term return (1926-2012) for the S&P 500 is 9.69% per annum (according to Jeremy Siegel’s Stocks for the Long Run). Our investor has beaten the market by a whopping 70.31%! They could simply put the proceeds in an index fund for the next 10 years and they’d still beat the S&P 500 by 5.47% per year.

That’s great if the margin of safety is realised in 12 months. But what if it takes longer? The bad news is that the longer it takes for the margin of safety to be realised, the smaller the margin of safety is!

MoS Graph

The chart above plots the after tax return (dark blue) and the historical long-term return of the S&P 500 (dotted line). As the chart shows, the margin of safety disappears after approximately 6 years.

But this is actually being overly generous. The margin of safety really disappears after 2-3 years. This is due to the skewed distribution of value stock returns. Remember, approximately 60% of value stocks turn out to be disappointing investments. Subtracting the cost of these duds means that the margin of safety really has to close within 2-3 years (shaded area) for a value strategy to have a decent chance of beating the market.

But don’t take my word for it. Benjamin Graham understood that a margin of safety shrinks over time. That’s why advised investors to hold stocks until they had returned 50%, or, if a stock hadn’t met that return objective by the “end of the second calendar year from the time of purchase, sell it regardless of price.”

The need to sell stocks, either because the margin of safety has closed or because it’s unlikely to close anytime soon, results in the need to find a steady supply of new investment ideas. This creates a potential reinvestment risk for value strategies, the topic of the next post in this series.  

  1. Value Investing – Don’t get Skewered!
  2. Losers in the Driver’s Seat
  3. Margin of Safety – the Clock’s Ticking
  4. Reinvestment risk – Got any ideas?
  5. Growth – the Enemy of Value Stocks
  6. When cheap isn’t cheap
  7. Hitting the target
  8. We liked it at $10, so we like it even more at $7
  9. Value Investing – Some Suggestions

Thanks for reading, I hope that you enjoyed this post.

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