Jun 2, 2008|
Investing framework: Margin of safety
In the previous article, we addressed the question of concentration vs. diversification at each stage of the investment process. We also mentioned that after generating, eliminating and finally selecting investment ideas, we must apply one final test. This final test is the "Margin of safety". In this article, we shall discuss the concept and its application.
Earlier articles in the series
Margin of safety- ConceptMargin of safety
Margin of safety is one of the most important and timeless investment concepts. In The Intelligent Investor, Ben Graham defines it as "A favorable difference between price on the one hand and indicated or appraised value on the other. That difference is the safety margin. It is available for absorbing the effect of miscalculations or worse than average luck." He also mentions, "The margin of safety is always dependent on the price paid. It will be large at one price, small at some higher price, nonexistent at some still higher price."
Margin of safety- Application
Margin of safety is the universal thread, which stitches together the investment approach of many successful investors. Let us have a look at some of them.
||Sources of margin of safety
|High quality companies at reasonable prices
||Buffett (Later), Charile Munger, Phil Fisher
||Economic goodwill, Price
|Lower quality companies at cheap prices
||Graham, Buffett (Early), Walter Schloss
|Companies with high growth prospects
||Phil Fisher, Peter Lynch
||Qualitative understanding of the business
|Event based arbitrage
||Price, Macro variables
||Demand & supply mismatch
||Bubble/disequilibria in macro variables
The table is neither precise nor exhaustive. But it highlights three points. First, margin of safety arises from multiple sources. For example, Ben Graham laid a lot of emphasis on the price element (it continues to be a vital source), but Warren Buffett expanded the concept to qualitative factors as he progressed in his investing career influenced in part by Charlie Munger and Philip Fisher. Second, the various sources provide varying degrees of margin of safety. While it is difficult to precisely sort the sources in a descending order of margin of safety (perhaps it depends on the investor’s aptitude), the clear winner is economic goodwill. Third, the source of margin of safety decides important aspects of a portfolio such as the extent of diversification and time-horizon/ holding period.
We shall continue with our discussion on building an investing framework in the next article.
Reading is an excellent way to develop one’s investment framework. We urge you to refer to investment classics (books, articles and speeches) in the original.
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