What is margin of safety? And why you should care about it!
Investing using margin of safety means that you make sure you never pay more for an investment than you should. It’s making sure you leave a bit of lee way in case you’re too optimistic about the share’s value.
Here’s what Benjamin Graham had to say about margin of safety: Margin of safety for any investment is the discount between your carefully and conservatively calculated ‘true’ value of the business and the price you paid for its shares.
In other words, if you calculate that a company is worth R1,000,000 and you pay R600,000, your margin of safety is R400,000 (R1,000,000 intrinsic value – R600,000 purchase price = R400,000 margin of safety).
So the margin of safety is there to make sure your money stays safe no matter what happens to the investment you bought. It gives you a safety buffer to make sure you don’t lose your shirt if something unexpected happens...
Follow this one rule and make sure you never lose big unnecessarily
If there’s one thing I try my best to do is avoid losing big on shares. That’s why I try and keep a big margin of safety.
This means there’s limited downside in a share, even if something bad happens.
And that’s where the buy ranges I give you come in...
The buy range I publish is the upper end of the margin of safety. Generally I try and have a margin of safety that limits losses to 30% at most. So buying above my buy range (with a smaller margin of safety) could be financial suicide.
Take Coal of Africa for example. I tipped the share at 500c with a buy range up to 510c. A few weeks ago, the share ran up to 570c... Should you have bought it at this level?
Def initely not! It’s too far from my buy range and, at that level, you barely had any margin of safety left. That’s why I set my buy range at 510c. To avoid you losing money from buying higher!
The share’s very volatile, and I knew it could easily drop as much as it gained within a few days!
And my suspicion proved tr ue, the share dropped to 410c as liquidity dropped.
Now if you bought at 570c, you’re probably sitting there thinking you should be selling the share now, with a loss at 28%... But if you bought at 500c, your paper loss would be far more manageable at 18%, and you can hold onto the share for a quick recovery far easier!
How do you figure out what a share’s margin of safety is?
There are many ways and some are basic and easy with others being hours of hard work. But in the end, it all comes down to research and getting the right numbers.
Think about last month’s tip, TransHex. For that company we know just the cash the company has on hand is worth more than the company itself…
Not even to mention that it’s profitable. This information gives you a ‘back-of-the-matchbox’ margin of safety.
You can also look at things like net asset value and tangible net asset value. These f inancial ratios show what a company is really worth if it had to be liquidated and sold today. So if the share price is smaller than the company’s net asset value, you’re buying the share with a big margin of safety.
If ever you’re ever left wondering if you should buy an expensive share with a tiny margin of safety, don’t!
Remember, the more expensive a share the more it stands to fall…