In a recent discussion I had with a few fellow investors the topic of a margin of safety (MoS) came up and whether a discounted cashflow (DCF) model for determining stock valuation was still relevant.
In August of 2008 I wrote a detailed stock analysis tool, Taking Stock in IGM, which detailed my independent process of fundamental analysis for companies I invest in. The overall process takes considerable time; especially when in today’s information age DIY investors can access multiple analyst reports, opinions and trends within a few moments.
It’s no surprise to long-time readers of this blog that I was taught my investing principles from an old-school perspective; you do the work required to understand as much about the business as you can and then you assess what price you’re willing to pay for ownership in the company. Many investors can make a decent return by simply investing in the market (index investing) or picking the lowest performers in a 12 month period (Dogs of the DOW), but individual stock investment cannot be done successfully over the long-term, in my opinion, unless you have a disciplined approach to managing your portfolio and a core focus for your stock selection.
Benjamin Graham, the famed value investor, is likely the person best known for using a margin of safety; the difference between the intrinsic value of a business and its market price. Graham used quantitative measures and ratios such as price to book (P/B) and price to earnings (P/E) along with fundamental analysis to determine his margin of error.
Evaluating the true value of an investment at times can be difficult so a margin of safety allows an investor to protect themself by providing a buffer for their own individual error.
From Taking Stock in IGM,
A margin of safety (MoS) is my attempt to mitigate risk in stock analysis and concentrate on one of my foremost objectives when investing: preservation of capital. I don’t like losing money. No investor can bat .500 all the time and a margin of safety helps to protect an investor from making a poor decision on an investment. I have to consider that through all my analysis there is the possibility that I missed something fundamental that holds the potential to send an investment down 20%….a MoS gives me a range of movement in the stock price that I feel comfortable holding a stock through over a period of time. This is also called the discount rate and investors use it in a discounted cashflow analysis (DCF).
That quote accurately sums up the importance to me of requiring a MoS in each and every investment I assess before my initial investment. I’ve been known to detail my own personal Value Traps that I learnt important lessons from. A margin of safety also helps to protect me psychologically on long-term investments in my portfolio. When I price in a margin of safety before I buy a stock I’m making an assessment of what I’m willing to give up as error without having to change my approach to an investment.
A good example of this would be my investments in Royal Bank (RY), Toronto-Dominion Bank (TD) and Bank of Nova Scotia (BNS) back in 2008. Each of these Canadian banks is a core holding within my Dividend Growth Portfolio (DivG) that I had purchased at prices with a MoS built into my evaluation. When the credit crisis took hold I was the first investor to question their viability, but looking at my fundamental analysis I felt comfortable that my margin of safety protected me to a certain extent and that if a reasonable MoS were still present they may be investments I would look to add to; which I did during their subsequent price erosion.
How Do You Determine Your Margin of Safety?
There’s no right or wrong way to develop a margin of safety for any specific investor. What it really depends on is how you approach investing. For myself, as a value oriented investor, a MoS is much more important because of my principle focus; don’t lose money. Capital preservation is my main focus which is why I like dividends and value investing so much.
It’s not uncommon for me, in my DDCF models (dividend discounted cashflow), to input a margin of safety of 25-50%. I generally like 25% because I assume that I am wrong with an investment 1 in every 4 times I select a new stock. Some might argue that I’m either overconfident or too cautious but history has taught me that I don’t necessarily lose money 1 in every 4 times I invest, but my expectations change about 1 in 4 depending on how a stock performs. I’m not responsible for how the market perceives an investment so I have to assume that at times either I am wrong or the market is as price fluctuations occur in response to perceptions in the market. The mistake an investor does not want to make is to look for a discount where one doesn’t exist. If Company ABC is trading at a 35% discount to its peers even before you start to examine it as a potential investment that doesn’t qualify as a MoS!
For most new investors with limited experience in fundamental analysis I would encourage a fairly hefty margin of safety (25% or more). For a more experienced investor with a diversified portfolio they may not be as concerned with safety because they’re protected through diversification. The difficulty for most new investors is that their capital is limited and they usually start with only a few stocks which leaves them exposed to greater risk.
I have a fairly diversified and balanced portfolio, but I still implement a MoS in all of my investments because for me capital preservation is as important as being paid (dividends). What’s not a realistic MoS for an equity investment is something like 80%; if you want that type of safety you really want to invest in fixed income only (Bonds, GIC’s, T-Bills, etc).
As you begin to develop your margin of safety and apply it to investments you’ll quickly find that specific stocks (usually consumer staples) show up routinely. This actually helps to show you where stability can be found in a market in relation to valuation.
Give it a try and let me know how you do. If you use this approach already, what’s comfort zone and Margin of Safety?
Disclosure: I have equity positions in all stocks mentioned at the time of this post
I am not an expert in fundamental analysis, and I do generally buy ETFs. However, I have a few individual stocks – all low PE and high dividend. I try to ask myself the following question: If there was a big wipeout in the market – say the indexes went down 25% – would I still feel comfortable holding this stock or even adding to it, i.e. would I trust my original investing thesis? If yes, its on the buy list; if not, forget about it. By the way, I know the Canadian banking system is much more stable and better regulated than that of the UK or the US, but bank stocks still scare the living daylights out of me.
Banks are definitely difficult to assess. I have an upcoming blog post that will be discussing this topic specifically.