Margin of safety. Warren Buffett calls them “the three most important words in all of investing.” Value-investing dean Benjamin Graham gave rise to the term in his classic book The Intelligent Investor, where he devoted an entire chapter to expanding on its importance as the central concept in any investment operation.
The idea of a margin of safety stems from the reality that no investor, not even Buffett, can determine the exact intrinsic value of any business. Because the intrinsic value is derived from an investor’s assumptions, the value is merely an approximation. Yes, an investor as skilled as Buffett will probably have a better approximation of intrinsic value than most, but it is still an approximation nonetheless.
This is why the margin-of-safety concept is of paramount importance. It gives the investor a degree of protection from the market’s uncertainties. A margin of safety of at least 40% of intrinsic value typically proves satisfactory, although the wider the margin, the better. In any event, you will rarely lose money investing if you always demand a satisfactory margin of safety.
And demanding one means that your first goal will be to focus on return of — not on — capital. Once you’ve determined a floor price based on a fundamental valuation approach, then investing at or below that floor price ensures that your return of capital is not at a high risk of loss.
Sniffing out discounts
The most common type of margin of safety occurs when a company’s tangible assets far exceed its market value. Graham was famous for seeking out net-net values, or securities selling for less than two-thirds of current assets, less all liabilities. That’s the ultimate margin of safety. But as more investors have entered the game, these special situations have become exceedingly more difficult to find.
Yet it is still possible to find businesses that trade at significant discounts to intrinsic value.
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