What is margin of safety? And why you should care about it!
Basically investing using margin of safety means that you never pay more for an investment than you should. And more than that, it’s making sure you leave a bit of leeway in case you’re too optimistic about the share’s value.
If your margin of safety is big enough, it means you get a portion of the company you invest in for free!
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, for example, 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) or 40%.
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 in case something unexpected happens, and makes sure you don't lose your shirt...
Follow this and make sure you never lose big unnecessarily
If there’s one thing I try my best to do, it’s not to lose big on shares when I can avoid it. This is why I aim for a big margin of safety when investing. It 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...
You see, 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 Zeder for example. I’m tipping the share at 400c this month. But the company’s published value is 527c. That means your margin of safety is 127c or 31%.
That leaves a lot of space for ‘bad’ things to happen before you lose any value in the company you invest in.
But should things turn up for Zeder, the big discount means you bought a bargain and your gains should be big.
But what happens if you buy Zeder at say 500c?
It means your margin of safety is only 27c or 5.4%.
That’s definitely not where you want to buy the share. It means if one of the companies it owns drops profit by 5%, you will lose value in the company as its value drops to 500c.
But the guy who bought at 400c will still hold the share at a discount!
So try and stick to my buy range. I set it at levels to keep a margin of safety there so you can get FREE assets and downside protection.
How do you figure out what a share’s margin of safety is?
There are many ways. Some are basic and easy while others take hours of hard work. But in the end, it all comes down to research and getting the right numbers.
I like using things like net asset value and tangible net asset value. These financial 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.
You could even forecast a company’s future profits, and determine what it’s really worth based on that. If the share is selling at a discount to this figure, it means you’ve got a margin of safety.
In the case of a company like Zeder, you can even go and look at every single investment it owns, what it paid for them and what other companies are willing to pay for them now. You sum that up and then you have a value for the company!
As a rule you want the margin of safety to be around 30%. That provides you with enough leeway even when the company is in a sell-off!
If ever you’re 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…