What we pay for the shares of a company can vary a lot as stock markets rise and fall. What we should pay is an entirely different question. While having an informed estimate of a company’s intrinsic value is a good starting point, peace of mind also requires protection against the risk of permanent capital loss.
This is where the concept of a margin of safety, introduced in 1934 by the renowned investor and author Benjamin Graham, becomes important. Shortly stated, it entails investing only when the share price of a company trades at a significant discount to its estimated intrinsic value. A wide margin of safety offers protection against unforeseen setbacks and nonassessable risks and still leaves an investment looking sound. When combined with a deep understanding of a company’s fundamentals and risks, a margin of safety provides the protection many investors seek when investing capital in volatile stock markets.
In addition to protection, a margin of safety also offers the potential for an attractive return on investment. Investing at a price that is significantly below the estimated intrinsic value per share increases the odds that a company’s share price will eventually be revalued by the market. If the company in question continues to develop in line with expectations, other investors will ultimately take notice of the undervaluation. And in the event the company would unexpectedly underperform in the long run, the margin of safety still protects the investment.
We do recognize that buying at low prices often requires patience. Stock prices can remain low for a long and unknown period. It is far more difficult (if not impossible) to predict when a share price will rise than merely demonstrate that it is cheap. But in the meantime, many positive things can happen to a company that trades well below its intrinsic value. For example, it can be acquired, it can buy back its own stock, results can improve, et cetera. For these reasons it makes a lot of sense to concentrate efforts on identifying undervalued companies instead of trying to predict short term price movements.
A simple example given by Benjamin Graham illustrates the concept of margin of safety.