MINNEAPOLIS, MN–(Marketwired – May 1, 2013) – “…To distill the secret of sound investment into three words, we venture the motto, ‘margin of safety’.”
Investors consider many factors in building their stock portfolios — diversification, P/E ratios, fundamentals, earnings growth, and timing, among others. But the most important factor of all may be one that investors often overlook — the margin of safety, according to author Frederick Martin of Disciplined Growth Investors.
Buying a stock with a margin of safety means paying a favorable price that reduces the down side risk and increases the upside potential. To put it in simple terms, if you think a stock has a value of $10, for example, you would want to buy the stock at a price below $10 in order to give yourself a margin of safety.
“Simply adding one more stock to the portfolio for the sake of diversification actually contributes nothing to your margin of safety,” explains Martin in his recent book, “Benjamin Graham and the Power of Growth Stocks” (McGraw-Hill). “Buying stocks without knowing the margin of safety can be tantamount to investment suicide.”
It was the late Benjamin Graham who first introduced the concept of margin of safety to the investment world. Graham, an early stock market pioneer who may be best known as Warren Buffett’s mentor, introduced the margin of safety concept in his book, “The Intelligent Investor.”
“To have a true investment, there must be present a true margin of safety,” wrote Graham. “And a true margin of safety is one that can be demonstrated by figures, by persuasive reasoning, and by reference to a body of actual experience.”
Graham felt that a sufficient margin of safety could turn even a mediocre stock into a good buy. “It is our argument that a sufficiently low price can turn a security of mediocre quality into a sound investment opportunity — provided that the buyer is informed and experienced and that he practices adequate diversification,” said Graham. “For if the price is low enough to create a substantial margin of safety, the security thereby meets our criterion of investment.”
Martin, on the other hand, is more interested in buying the stocks of great companies to hold for the long-term, which requires a more comprehensive analysis process. He needs to determine not just what the stock is worth today, but what it will likely be worth several years from now. Then he factors in the average annual returns he wants to earn by holding the stock (“hurdle rate”) and determines the price he would need to pay for the stock today to achieve his long-term objectives.
KEYS TO BUILDING A MARGIN OF SAFETY
Martin suggests that investors follow three key rules for building a margin of safety:
1. Know what you own.
2. Develop reasonable estimates of future value.
3. Set a reasonable hurdle rate.
Step one (know what you own) means doing the proper due diligence on the stock you’re interested in buying. Research the company thoroughly and determine if it’s really a company you want to own for the long term.
Step two (develop reasonable estimates of future value) means looking at the company’s future prospects and projecting a future growth rate to determine the company’s potential value several years from now. Martin, the president and chief investment officer of Disciplined Growth Investors in Minneapolis, prefers to use a seven-year time frame in setting the margin of safety for the stocks he buys. That means calculating an estimated intrinsic value for the target company seven years in the future. He does that by determining the company’s intrinsic value, estimating its growth rate in future years, and multiplying the current value by the projected seven-year growth rate. For instance, if you determine that a company is worth $10 per share today, and has a projected annual average growth rate of 7 percent going forward, that means the stock would be worth about $16 in seven years.
Step three (set a reasonable hurdle rate), means deciding exactly what average annual return you would like to earn from your investments.
Only then can you determine an accurate margin of safety for the stocks you’re buying.
For example, if your hurdle rate is 10 percent, you would need to buy your stock at a price low enough to allow you to earn your 10 percent return for the next seven years — which, based on the compounded return tables, means you would need to essentially double your investment every seven years. That means, if you want to buy a stock that you think will be worth $16 in seven years, the most you would should pay for it today is $8. But you would give yourself a better chance to reach your goal if you could buy the stock at $7 or even $6. The lower the price, the larger the margin of safety and the better your chances of achieving your investment goal.
But what if you can’t buy the stock at a price low enough to give you your target return and an adequate margin of safety? Easy answer: don’t buy the stock. Either find another stock to buy that does meet your criteria, or wait for the market to hit a bump in the road that knocks the price of your stock down to a level that gives you a chance to hit your hurdle rate with an adequate margin of safety.
“The concept of a margin of safety may have been Benjamin Graham’s greatest gift to all investors,” Martin said. “It should be an essential part of the process for every investment decision you make.”
But even Graham realized that a margin of safety alone wouldn’t assure success with any stock. “Even with a margin [of safety] in the investor’s favor, an individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss — not that loss is impossible.”