Have you ever wondered why you did not get attractive returns on a blue chip stock that you bought two years ago? Ok, the stock has given you 12% returns per annum, which is not bad. But, during the same period there are scores of other stocks that returned 50% over the last two years. What did you miss out in your stock selection? Obviously, you missed out on the concept of margin of safety. So, what exactly is margin of safety? A good company is not always a good investment!
Margin of safety was first put forth as an investment idea by Benjamin Graham, the father of modern investment theory. The idea of margin of safety has been applied at length by Warren Buffett and has been one of his key success factors. Margin of safety is the comfort level or the cushion that the investor has in a stock when he buys the stock at a particular price. It is based on the premise that a great company can be an awful investment if purchased at an awfully expensive price. So, even if the company is a great company with an excellent management track record, you need to identify the point at which the margin of safety is the maximum for that investment.
Understanding Margin of Safety with (Hindustan Unilever and Reliance Industries)
To understand the margin of safety with respect to stocks, we need to understand the tipping point. The tipping point is the point at which the margin of safety is the highest and makes the most business sense to buy the stock. Check the comparative five-year price chart of Hindustan Unilever and Reliance Industries below:
Very quickly, it can be seen that both RIL and HUVR have tripled in price in the last five years. However, the real outperformance came in the last 18 months (the shaded portion) when the stocks outperformed by a huge margin. Both the companies had their own reasons for the outperformance. RIL had just launched Reliance Jio and its salivating price point was just turning the Indian telecom market upside down. Hindustan Unilever was more a case of benefiting from greater rural spending and the launch of GST. It is evident that for both the stocks, the tipping was around the first quarter of 2017. Had you bought both these stocks in 2013, you would have been sorely disappointed for the next three years with both these stocks. That is why, it becomes so critical to identify the tipping point where the margin of safety is the highest.
Margin of safety is always with reference to the intrinsic value of the stock…
A stock’s intrinsic value is based on a variety of factors. There are financial factors such as growth in sales, growth in profits, operating margins, P/E ratio, and dividend yield. However, it is not just about quantitative factors. There are qualitative factors as well such as the management quality, entry barriers created by the product, corporate governance standards, and brand reputation. The final valuation is arrived at by combining the impact of these financial and non-financial factors. This is what gives you the intrinsic value of a stock.
It is not just enough to know if the stock underpriced or overpriced. You need to know the extent to which the stock overpriced or underpriced. It is this gap between the market price and the intrinsic value that is known as the margin of safety. For an investor, if the market price is substantially lower than the intrinsic value of the stock, the stock offers a high margin of safety and is a good stock to invest in.
Here is why margin of safety matters
Margin of safety is an insurance against market volatility. Shifts in interest rates and inflation could change the intrinsic value rapidly and that is why a higher margin of safety is the key.
There are some risks we are aware of and some risks we simply fail to recognize. Benjamin Graham referred to these risks as the “Unknown-Unknown”. These risks can be best handled by the margin of safety concept. It is estimated that a margin of safety of 25-30% adequately factors in most of the risks implicit in buying a stock.
How buying stocks with margin of safety can give above-market returns
The above chart captures how IIFL Asset Management (Y-Axis prices need to be multiplied by 10) has used the concept of margin of safety to buy stocks early and continued to add these stocks as long as the margin of safety was visible in the stock. That is how the concept can be applied in practice to your investment decisions.