Margin of Safety: The Lost Art
In another era, Benjamin Graham, one of history’s greatest investors, opined in The Intelligent Investor about the importance of including a margin of safety in assessing the quality of any investment: “to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.” Graham’s many adherents, including the fabulously successful Warren Buffett, Bruce Berkowitz, and Seth Klarman (who even wrote a book entitled Margin of Safety), all also emphasize the importance of the concept of margin of safety.
Klarman says: “There are only a few things investors can do to counteract risk: diversify adequately, hedge when appropriate, and invest with a margin of safety. It is precisely because we do not and cannot know all the risks of an investment that we strive to invest at a discount. The bargain element helps to provide a cushion for when things go wrong.”
Each of these supreme investors agree about the power of recognizing that the future rarely, if ever, unfolds how you modeled it to unfold.
So what is the lost art of the margin of safety? In short, the margin of safety is a “fudge factor,” a specific amount of extra conservatism built into your estimate of value for a security, because:
- The future is unknowable.
- Preservation of capital, not return on capital, is Job One of investors.
- Your model is inevitably wrong.
Margin of Safety for Equity
Qualitative definitions of the margin of safety are mostly in agreement with one another and adhere closely to the definition given above. Yet, interestingly, there is no agreed upon quantitative definition of the margin of safety. This is what makes this concept an art!
To inspire your imagination, here are some possible quantitative ways of calculating the margin of safety:
If (Fair Value ÷ Market Price) – 1 ≥ Margin of Safety → Buy
Here a research analyst estimates the fair value of the equity of a business and compares this estimate to the market price. In order to purchase shares, the fair value must exceed the market price by at least the analyst’s preferred margin of safety. Here the margin of safety is arbitrary.
In my career, I usually used a margin of safety of 15%. Why? Because I figured that my fair value estimate was likely off by ±15%, on average (i.e., a 30% range). For Google (GOOG), this means your fair value estimate must be $635.31 if its stock price is $552.44.
If (Fair Value ÷ Market Price) – 1 ≥ Coefficient of Variation → Buy
My use of 15% above is entirely arbitrary. Clearly for some businesses where it is difficult to estimate their fair value, a 15% level may not make much sense. Likewise, shares in a utility, where cash flows and costs of capital are easier to estimate, you might use a lower margin of safety. If you believe this is the case, then you will like this measure better.
Here you want your margin of safety to be at least the coefficient of variation. The coefficient of variation is calculated as: 1-year standard deviation ÷ 1-year average stock price. Take Apple (AAPL), for example, its standard deviation over the last year is 14.9, and its average stock price (split-adjusted) is $102.02, making for a coefficient of variation of 14.6%. An analyst using this method would want her estimate of fair value to be $116.91.
Margin of Safety for Fixed Income
Fixed-income securities are a contractual obligation between a borrower and a lender. This contractual nature tends to shift the analysis for fixed-income analysts away from the valuation of individual securities, and instead onto an evaluation of the credit worthiness of the issuer. Analysis at that level is definitely one version of a margin of safety. However, many analysts simply take the overall credit rating of the issuer, or its issue, from a credit ratings agency at face value to determine the appropriate credit spread to value a security.
Here are some possible alternative versions of a margin of safety:
Collateral
Proof that the margin of safety is a lost art, even in the realm of fixed income, is the overwhelming number of “unsecured” issues in comparison to “secured” issues. Secured means the fixed-income security is backed by collateral — alias, a margin of safety. Thus, if you want greater margin of safety, buy more issues backed by collateral. In a mortgage-backed security, you would want high levels of equity backing the mortgages.
Use the Credit Spread of One Credit Level Lower
Fixed-income investors could also use a more conservative credit spread in their calculation of fair value for an instrument than that implied by an issue’s credit rating. So if an issuer has an A- credit rating, then analysts could use the credit spread for BBB+ issuers for a similar maturity length security in assessing fair value.
Add a Premium to the Credit Spread
Another alternative is simply to add an arbitrary percentage amount to an issuer’s credit spread. If the spread is 150 basis points (bps), an analyst could add 15%, or about 173 bps, to use when assessing the fair value of the instrument.
As an example, the fair value price of a €1,000 par, 3.5%, 2-year note — with a comparable euronote bearing an interest rate of 2.5%, and a credit spread for this type of issuer being 1.5% — would be €990.48. But, what if instead, the analyst builds conservativism into the spread, and makes it 15% higher, or 2.5% + [1.5% x (1 + 15%)] = 4.225%? Here the fair value estimate falls to €986.23.
Margin of Safety for Derivatives
Derivatives are the modern superstars of finance with many risk factors and sensitivities to these risk factors an explicit part of the daily discussion of such securities. So you would think derivatives must have a built in margin of safety. But I would argue that nowhere is margin of safety more of a lost art than in derivatives pricing!
Most derivatives investors do not have an independent assessment of the valuation of the underlying security. Instead, they take the market price of the underlying at face value because they simply want to calculate the price of the derivative itself. Likewise, the value of the derivative comes from a modeled price; consequently, the price of the derivative is taken at face value, too.
Risk management is handled after the fact by hedging. As the market fluctuates, derivatives investors simply adjust their hedge. But this assumption relies upon a liquid and stable market for these assets. If the market suddenly moves — exactly the moment when you want a margin of safety — it can be very difficult to adjust the hedge. In other words, there is no margin of safety built in to the valuation of derivatives.
Here are some suggestions for margin of safety for derivatives:
Have a Fair Value Estimate of the Underlying Security
I am guessing that to most of those involved in options trading this seems like a ridiculous consideration. But is it? If you get the options price correct, but the underlying security is massively overvalued and you are long calls, then you have some trouble on your hands, right? If you do not create an estimate of fair value, is there a source that you trust for such things?
Use Lower Volatility Assumptions
Option prices are directly tied to the volatility assumptions embedded in them. As a bit of conservativism, why not use a lower volatility assumption? Discount it in a similar fashion to those methods suggested above for other instruments.
Use More Conservative Assumptions for “The Greeks”
Different Greeks have different effects on different options. But if you are interested in preserving more of your capital and accounting more for an uncertain future, why not use more conservative assumptions for your Greeks?
In conclusion, margin of safety lies at the heart of the success of many great investors. Yet, it is a lost art. And not just in equity investing, Across the financial landscape, margin of safety is ignored . . . at your peril!
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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Hello Jason,
Good suggestions here. I particularly liked your point about using MoS in derivatives. MoS meet leverage.
Regards
Ashok
Hello Ashok,
Thank you for your feedback; I always take it to heart!
Yours, in service,
Jason
Good work Jason. Light thrown on intricate details and crucial areas deeply analysed.
Hello Apoorva,
Thank you for your kind words, I appreciate them.
Yours, in service,
Jason
I have always thought of the margin of safety calculation for stocks differently than the formula you give. I’ve always calculated it as 1-(market value/intrinsic value). For example, if a stock’s market value is $20 and the intrinsic value is $30, I see that as a 33.3% margin of safety whereas your formula results in a 50% margin of safety.
If you take it to the extreme, your formula results in nonsensical numbers to me. For example, if the market value is $5, and the intrinsic value remains $30, the margin of safety is 500%, while the way I have traditionally calculated it, I get an 83% margin of safety. In my mind, the margin of safety can’t exceed 100%.
I have always used the formula you give to calculate my potential return (assuming my intrinsic value estimate is correct), but calculate the margin of safety differently.
I’ve searched my value investing library and while there is much discussion about the margin of safety, I can’t find an actual formula detailing how to calculate it.
So food for thought, the concept is the key issue, but I’d like get your take on the different ways to calculate it.
Hi Doug,
Thank you for your passionate response to the topic of margin of safety. I share your passion for the conversation, too!
As I indicated in the piece there is no agreed upon quantitative definition of margin of safety. If you hunt through all of the materials from Graham and Dodd, including The Intelligent Investor and Security Analysis (and through various editions), you will not find a formal definition. If you think about it, this makes sense because the concept of margin of safety is a concept of prudence. Prudence requires judgment, and therefore unique, competent solutions to unique problems. In other words, no cookie cutter solution will work.
I have expressed to many over the years, including here on The Enterprising Investor, that knowing yourself is the most important thing as an analyst. The second most important thing is to develop tools that resonate with your consciousness. So I wholeheartedly support you in creating your own calculation for the margin of safety as it clearly supports how you see and understand the concept. Here I am referring to your statement, “In my mind, the margin of safety can’t exceed 100%.” In my mind, it doesn’t make much difference.
Yours, in service,
Jason
I agree with Doug for this case.
On top of that, I like to add my view that although MoS, by language, sounds like a quantitative measure, but in real life it isn’t one. To me, it is more like a qualitative judgement of feeling safe.
For example, we don’t calculate how much impact a door can sustain in order to feel safe (though very few still do, I think), but we observe the quality of materials, the producer’s reputation/branding, the technology of the door-lock and whatnot.
Same goes to investment. We don’t know EXACTLY how much the discount-to-intrinsic-value we need for EVERY investment in order to feel safe. We may feel safe to buy Apple Inc at merely 5% discount to intrinsic value but we would insist for 50% discount to buy Blackberry Inc. That’s more about art than science.
And that’s how Mr. Buffett evolved into buying great companies at not-so-cheap price, because he felt safe with those prices and the moats of the companies.
Hello Chee Fui,
I believe your comments are super insightful. Nice work! They really contribute to the conversation.
Yours, in service,
Jason
Hi,
For Graham & Dodd the Margin of Safety is the difference between the intrinsic value (fundamental value justified by facts) and the market value. Intrinsic and market values are equal only through coincidence. G&D assumed that the appropriate margin of safety for investments is 30-50%. Intrinsic value is whichever is greater of Net Adjusted Asset Value and Earnings Power Value. Another way of viewing intrinsic value is Net Adjusted Asset Value plus the Franchise Value.
Hello Magnus,
Thank you for adding this definition to the thread. Do you have a quote and reference for the above definition so that other readers of this article can find out more information? I am certain, that would be very helpful for some.
Yours, in service,
Jason
Nice job Jason. I am a big fan of this topic.
I keep a blog that tracks news about investors who employ a margin of safety. I also have links to information about Graham and the “SuperInvestors”. I write often about Klarman, Buffett, Marks, etc., and the behavioral theories and institutional constraints that allow for the existence of margins of safety.
http://www.amarginofsafety.com
Hi Ray,
Thank you for the kind words and for sharing your website with the audience.
Yours, in service,
Jason
The margin of safety that Graham talked about is rare today – and doesn’t always work as Brandes Investment Partners found out. You only ever make money when the lines turn up on the chart. Follow the lines and you eliminate the guess work, emotion etc. – you’re safer in a strong underlying trend than you are a strongly held belief that some company is undervalued – that should be all the margin of safety you need.
Hello Neil,
Thanks for sharing your views with the audience. We are always grateful that people take time out of their busy schedules to communicate. Margin of safety is a concept that is easily adapted to trends, too. Simply, by developing a decision rule that eliminates marginal trends, you build conservatism into your strategy.
Yours, in service,
Jason
The whole section about derivatives should have been cut. It’s just a put down on the derivatives traders. It’s clear that Jason despises them.
For example:
“Most derivatives investors do not have an independent assessment of the valuation of the underlying security. Instead, they take the market price of the underlying at face value because they simply want to calculate the price of the derivative itself.”
What the heck is that supposed to mean? A value investor who has calculated the intrinsic value of a stock can use options to implement part of his position. It’s not a black and white, either-or world. If a company is good, the entire capital structure can be considered for investing, plus the derivatives.
Perhaps vol is so out-of-whack high that it seems foolish not to sell some Put options. In that case the value investor has a clear idea of the intrinsic of the underlying stock. And in this case there’s no margin of safety for the option itself, as it is part of the implementation of the position on the stock.
Why bring up derivatives just to slam them down? Please cut that whole section out.
Other than that, the article is useful for me.
Hi Gerald,
Thanks for sharing your views. I have been on vacation for the past month so apologize for my delayed response : ) I see that I have touched on an issue for which you have passion.
In response to your points, I was very careful in my use of language in this article. I specifically focused on investors, rather than traders. In fact, if you execute a “ctrl-f” on the piece your mentioning of “trading” is the only reference. Also, I circulated this piece among my pals who work in derivatives and all thought this was an interesting piece with helpful observations. Last, I actually cut out a long section from the post that quoted important comments made by one of the Godfathers of derivatives, former US Treasury Secretary, Robert Rubin, in which he suggested that a fudge factor always be included by derivatives investors (and traders) because the future is always unknowable.
Again, thanks for your sharing your passion with everyone.
Yours, in service,
Jason