3 Ways to find a margin of safety

Ben Graham may not have invented the term ‘margin of safety’, but he did popularise it for investors by making it a core part of his investment philosophy. But what exactly does a margin of safety mean when it’s applied to investing, and how can you go about finding it?

An example of a real-world margin of safety

If you’re going to build a bridge for road traffic, you probably want to know what the heaviest vehicle is that’s going to cross it.  After that, you might want to know how many of these could conceivably cross the bridge all at the same time.

So you might say a 50-tonne truck is the biggest, and the bridge could have ten all at the same time, so the maximum load could potentially be 500 tonnes.

Building the bridge to only take 500 tonnes maximum would then be a terrible idea.  What if somebody built a truck that weighed 60 tonnes?  What if you had ten 50-tonne trucks on a very windy day or when there was an earth tremor?  What if you’re calculations are wrong, and the bridge is slightly weaker than you expected?

The basic principle of a margin for safety is that it in some way protects you from both the unknown and your own errors of judgment and calculation.  So how can we apply this thinking to investments?

Diversification – Protection when it all goes wrong

Diversification is primarily the margin of safety for when an investment goes wrong.  If you buy a stock that looks attractive but turns out to be a lemon and, in the worst case, goes bust, how much of a problem is that?

The answer depends on how big a position you took.  If you put 30% of your net worth into the company, then you’re going to be very unhappy indeed, to put it mildly.  30% down the drain is very bad news because you’ll need the rest of the portfolio to gain 50% just to get back to zero.

However, if you only had 3% to 5% invested in that company then while you might be miffed, it probably wouldn’t be bad enough to make you throw in the towel.

In fact, that’s a handy measure of maximum position sizing right there.  Just think about your biggest holding going bust.  If that would make you want to sell everything and go back to index tracking or even cash, then the position may be too big.

Low debt – protection from the economy and bad management

Nobody needs to be reminded of this these days, but economies can go down the tube.  When things turn rough, it’s the companies with tons of debt which are in trouble first, and it’s the same companies that tend to go bust or take forever to bounce back.

How much debt a company can handle depends on how stable the company’s cash flows are and how cyclical the industry is, but if you stick to low-debt companies, then much of that detail can be glossed over.

Investors and accountants have developed various ways to measure company debt, the basics of which are relatively simple.

Competitive advantage – protection from capitalism

Capitalism is a tough game.  Very few companies survive for prolonged periods of time while the vast majority are born, thrive (or not) and then fall by the wayside as competitors fight them for every penny.

Without a competitive advantage, a company’s existence may be more precarious than you think, low debt or not.

The most obvious sign of a competitive advantage is a long history of profitability and growth without the use of excessive leverage.  High margins and high returns on equity and capital over the long term are other popular signs.

Low valuation multiple – protection from Mr Market

The third leg of the margin of safety concept is valuation.  You can be holding a well-diversified group of high-quality, low-debt companies with competitive advantages, but if they are bought when Mr. Market is happy, then your margin of safety is missing what may be the most important piece.

If the market turns bad, if a company makes a mistake, or if another asset class comes into favour, Mr. Market can change his mind on valuations in a minute, and holdings of overvalued stocks should beware.

Technology stocks in the late 90s are an obvious example here, so I’ll use the example of Vodafone (which I currently own).

The company has produced very good financial results since the 1990s, but investors have been rewarded by a massive collapse in the share price between 2000 and 2002 and a relatively slow rate of share price growth since then.

How could a growing company reward shareholders with a falling share price?

The answer is in the starting valuation.

In 2000, the company’s share price was 400p while its earnings were around 5p. That gave the shares a PE ratio of 80, which is way above the normal range of 10 to 20. Even if the company grew four-fold, it would still have a PE ratio of 20, which is above average.

This left a massive gap between the actual share price (400p) and where the share price could be if the valuation were not so inflated.

By 2002, the company was still priced at the top end of what could be considered reasonable, with a PE of about 20. But it didn’t get to that PE by growing its earnings four-fold; instead, its earnings were still around 5p, but the share price had collapsed to around 100p.

That collapse was driven by a collapse in Mr Market’s sentiment rather than a collapse in the company. If the shares hadn’t been so highly rated in the first place, such a massive collapse would have been impossible.

For every stock I look at, I’m thinking about those four margins of safety:

• Does the stock diversify my portfolio, and is my position going to be small enough so that I can mentally accept it going bust?
• Does the company have a low or easily manageable level of debt?
• Is there a competitive advantage?  Can I see proof of this in a long history of profit, cash flows and growth?
• Am I buying at a low price so that I have some protection from Mr. Market’s wild mood swings?  Does Mr. Market only have to be moderately cheery for me to make a decent profit?

If a stock can tick all of those boxes, then it might be worth a deeper look.  If not, then it’s probably time to move on to the next one.