The margin of safety is a phrase coined by the legendary investor, Benjamin Graham, former professor and mentor to Warren Buffett. Graham introduced the concept of intrinsic value, which approximates a company’s business value. He observed that a company’s stock price spends much of the time deviating from this intrinsic value, at least in the short run. Over such short time periods, stock price movements have a very tenuous connection to fundamental business values, with stock prices changing a lot more than the underlying business values. Over longer time periods, the trend of stock prices tends to closely track the direction of underlying business values.
Graham opined that because of this price-value convergence over time, you can address investment risk by buying a stock whose market price is comfortably below the intrinsic value of the underlying business, as the difference represents a discount offering a margin of safety, in case subsequent developments indicate the company’s intrinsic value to be lower than originally thought. This concept is central to what we, and most other value-oriented investors, look for when evaluating promising investments for purchase. We want to buy at a huge discount for our clients.
We will buy a stock for clients if we feel it is selling at a big enough discount to its long-term business value so that it has a reasonable opportunity to generate satisfactory returns, even if we might have to wait several years. Patience is critical. We try to make the stock price movements our clients’ ally. When prices are well below the underlying business value, we buy for clients because a margin of safety exists. Conversely, when prices greatly exceed such value, we sell. We can’t predict exactly how long it might take for an investment to appreciate, if at all, but from experience we find around two years is a reasonable period to allow for the investment to work.
We seek a margin of safety that is large enough to mitigate investment risk, while at the same time provide attractive appreciation potential even if the gain is spread out over a multi-year period. However, when it comes to out-of-favor investments, operating issues often can (and do) get worse before they get better. Since we don’t have a crystal ball, we will not be able to catch the bottom in the stock price. Worsening consensus sentiment could cause the stock price to continue dropping, creating an even bigger discount (or margin of safety) to intrinsic or fair business value. Such short-term price drops are generally no cause for concern if a long-term investment time horizon is maintained and the business fundamentals remain intact to justify a turnaround in the company’s fortunes. Depending on the circumstances, it may be a good opportunity to buy more.
Another way of looking at the margin of safety is to think of it as an attempt to get more business value at cheap prices. Mason Hawkins, the legendary investment manager at Longleaf, has coined the term "price-to-value" ratio to measure this concept. The lower this ratio, the bigger the discount enjoyed when making an investment, and the larger the long-term return potential as the discount closes over time due to the eventual convergence of price and value. In addition to closing of the discount, benefits may also result from the increase in the business value of the company as it grows over time.