What is Margin of Safety?
In accounting analysis, the safety margin is the difference between the actual (or budgeted) outcome and the critical point (zero point volume).
When the company’s sales are higher than the zero point volume, the company has a positive safety margin. In the case of sales volumes that are lower than the zero point volume, a loss arises in the business, ie a negative safety margin.
Margin of safety and psychology
As the market can be likened to an erratic and schizophrenic person, Mr. Market (From Benjamin Graham), stock prices fluctuate very much.
This fluctuation has nothing to do with the intrinsic value of a stock. The share price fluctuates as the market is often inefficient at valuing companies and our job is to give companies as accurate a valuation as possible through fundamental analysis.
The reason why the market is inefficient can be due to many reasons. As humans have a herd animal behavior, the stock market is affected by human psychological action.
Momentum stocks that are doing very well tend to be very overvalued as everyone is going on a train that has left the platform a long time ago.
This behavior often leads to companies being horribly overvalued. Companies that instead suffer from bad news or more difficult periods tend to be severely punished and undervalued.
Hennes & Mauritz is a good example of this.
Not many investors want to buy the share at present and the company looks undervalued on paper. As people tend to exaggerate and follow the herd in situations like this, the stock is very depressed.
Since the market in many cases is not rational, it is up to us to be. We must go our own way and do our own analysis of the company.
Through this series of posts, I hope I have given you the tools to do just that. But the underlying value one arrives at through fundamental analysis is of course only an estimated value and therefore one must have a safety margin in case the analysis turns out to be partially incorrect.
The value you arrive at yourself is the company’s intrinsic value.
As our analyzes are not always perfect, we want to buy shares at a price that is below our intrinsic value. The difference between the share price and intrinsic value is our margin of safety.
Margin of safety calculation
Margin of safety is often expressed as a percentage and represents how much cheaper the share price is in relation to intrinsic value.
Margin of Safety = 1 – (Current Stock Price / Intrinsic Value)
Let’s say that Hennes & Mauritz’s share costs $200 per share in this now and the share has fluctuated between $250 and 160 per share.
After a thorough fundamental analysis, you will come to the conclusion that the fair value of the share is somewhere around $240 per share.
The fear is that some assumptions that the analysis has taken into account may be incorrect and therefore you want a safety margin. As the share is worth $200, you believe that you have a sufficient margin of safety.
Margin of Safety = 1 – ($200 per share / $240 per share)
Margin of Safety = 16.7%
In this case, you have a margin of safety of 16.7%.
This must be set in relation to the uncertainty factor in the assessment of intrinsic value. If you feel quite confident in your assessment of intrinsic value, the margin of safety does not have to be as large.
Value investors rarely buy growth stocks as it is normally difficult to get a margin of safety. This is because growth stocks are often highly valued due to high expectations.
The example below is an attempt to describe this in a more metaphorical way
1. Likeness: Bench Press Scenario 1 (Growth)
You have just started gym and you see really fast results and a huge growth in both strength and muscle volume. This makes you very confident that in the future you will continue to increase in strength at a fast pace.
Your favorite exercise is bench press and your historical results are as follows.
- Month 1: Benches 50 kg / 110 lbs
- Month 2: Benches 60 kg / 132 lbs (20% increase)>
- Month 3: Benches 70 kg / 154 lbs (16.7% increase)
Month 4: Now it’s time to bench press again. You load at 80 kg/176 lbs, after all it is only an increase of 14.3 percent. In the past, you have increased the result far more than that and you have just started with creatine and protein powder.
You come to the conclusion that 80 kg should definitely not be a problem but you do it by assuming a variety of things.
You do not really know if the creatine will have any effect. Will the protein powder really have an effect. Have you overestimated your growth in strength?
How has sleep been? You start the exercise and the bar falls flat over your chest. You had no margin of safety to mitigate the case.
So you literally did not succeed in growing into the growth and the result is catastrophic. I think this parable is quite good if I may say so myself because it also highlights the problem that it is more difficult for growth companies to maintain high levels of growth the bigger they get.
It is much more difficult to double the turnover if the turnover is 100 billion instead of 1 million. Just like it is extremely difficult to double your personal best in bench press when it is 100 kilos/220 lbs instead of 50 kilos/110 lbs.
2. Parable: Bench press scenario 2 (Margin of safety, value investment)
You have been exercising for a long time and know your limitations and what to expect. You have a long history from which you can draw data and used it to draw conclusions. Lately, your bench press results have been as follows.
- Month 1: Benches 55 kg / 121 lbs
- Month 2: Benches 60 kg / 132 lbs
- Month 3: Benches 65 kg / 143 lbs
You feel a little tired today and do not really think you can break the result from last week. If you load 65 kg, you have a margin of safety of 0%.
You know that you managed 65 kg last week but are worried and therefore you want a safety margin. In the calculation, you take into account that you ate very well for a long time before your previous bench press attempts.
You also slept well and you had just started training and you have read that you often increase in strength very quickly as a beginner.
To be on the safe side, you decide to go back to a weight of 55 kg because that was the weight you started training with.
Even if you have eaten badly this month, slept badly and been stressed, you do not think that you can be weaker than when you started exercising.
In part, you have managed that weight before without any problems and it also means that you have a margin of safety of 15.4 percent.
You feel safe and confident with your decision.
Lift the bar off the stand and you lift the weight without any problems. If, contrary to expectation, you had not been able to lift the weight, you could have slowly and controlled tilted the bar so that the weights could slide off.
Is margin of safety a 100% accurate strategy?
If you use margin of safety to achieve excess returns, I think you should raise your discount rate and use the safety margin to protect yourself against incorrect analyzes instead.
Margin of safety is a protection against being wrong, and the more difficult a company’s future is to predict, the greater the protection required.
I probably do not think that as a private investor with a long horizon you should buy companies at a discount of less than 25%, no matter how stable and secure they are.
How good are you at valuing companies? How good are you at looking into the future? Valuation is, after all, just that, to assess probabilities in the future. Investment is not heavy on mathematics, it is heavy on predicting the future!
I mentioned earlier that the psychological part is the most difficult part when it comes to investing. It does not matter how analytical you are or how good you are at setting up models that calculate discounted cash flows if you do not have patience.
Finding a fair value for a company can often be easy.
Waiting to buy the company in the right position and then keeping the company while everyone else says that doomsday is near is anything but trivial.
Therefore, it is important to determine the right value for the company and then buy the company at a price below this.
It makes the psychological aspect of investing so much easier if you have done your homework.
The share price often diverges from the company’s fair value, but time is an investor’s best friend and over time the share price tends to converge towards the fair value.