The Intelligent Investor – 20 – “Margin of Safety” as the Central Concept of Investment

This is one of the most important concepts which we need to understand thoroughly for becoming a successful investor.

The margin of Safety concept is for getting saved in the future while unfavorable situations occur. If we have projected sales, PATM (%) for the next 2 years but also conservatively, we have made few haircuts on the projected sales, PATM (%) for making an investment decision for getting saved if any unfavorable situation occurs into the future. Or we can provide a valuation multiple in a conservative manner that protects us from future unfavorable events. This protection against the future unfavorable situation is known as the “Margin of Safety”. The major risk is not uncertainty but losing capital. We can make a good return while there is uncertainty. If we keep on playing the game without proper care for protection against future uncertainty then we always need to be depended on the luck.

Mr. Graham has mentioned that he looks for a greater margin of earning power compared with the bond rate. That means if the AAA bond rate is around 6% then we should buy a company with higher earning power then 6%. Now, the question comes that above 6% but what should be that rate- 7, 8, 9 ….? Such earning power rate should be depended on the quality of business, quality of financial, the stability of earning, growth of future earning, quality of management, future visibility of the business, cyclical nature among the business earnings, future return expectation by investing into the particular business, etc. If the business does not have a stable earning, quality of financial is average, cyclical nature of the business, etc. then we should make an investment at least around the twice of AAA bond rate, I.e. earning power at 12%. We should measure earning power on the PBT, CFO and FCF levels for better judgment.

We should focus on better chances of profit rather than chances for loss. If prices are low for the good assets then that provides us with an opportunity to make an investment with a margin of safety. If prices are too much higher than there will be no availability of any margin of safety.

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Few principles are given by Mr. Graham-

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We should not rely on the others’ opinions or optimism on the particular business rather we should focus on the data and arithmetic. Though the crowd does not agree with our view, our data and arithmetic support our view then we should stick with it. If we get over-optimistic towards our investment then we ourselves become a risk for us.

For not being ourselves as a risk for ourselves, there are few points which we need to focus –

II C20 03

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The above questions work as a checklist for removing our emotions from the decision making and make a better decision. We do not know the future and sometimes our best analysis will be turnout as a worst so that we need to keep the margin of safety with it.