“A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world.” ~ Seth Klarman
Margin of safety is one of the most essential principles of investing*. For investors to remove the uncertainties and reduce the risk associated with investing in the stock market, they should buy a stock when it is trading, its market price, at a deep discount to their estimate of intrinsic value.
Margin of Safety helps ensure that any uncertainties were factored into the purchase price. No matter how much time one spent evaluating investments, it is impossible to remove all of the uncertainties.
Billionaire investor Warren Buffett, CEO and Chairman, Berkshire Hathaway, compares margin of safety to driving across a bridge:
“If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety.
So, the more vulnerable the business is, assuming you still want to invest in it, the larger margin of safety you’d need.
If you’re driving a truck across a bridge that says it holds 10,000 pounds and you’ve got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay; but if it’s over the Grand Canyon, you may feel you want a little larger margin of safety.”
Companies with high profit margins, above average returns on invested capital, growing free cash flow and strong balance sheets have their own margins of safety, which might be worth considering when one is investing in businesses.
References:
- https://finmasters.com/what-is-margin-of-safety/
- https://finance.yahoo.com/news/thoughts-margin-safety-companys-profitability-170943149.html
*All investments are the discounted present value of all future cash flow.