Margin of Safety is a Risk Management concept that describes the difference between the Intrinsic Value of a security – such as a stock or a bond – and its market price. The term was originally coined by Ben Graham in his book Security Analysis and is considered to be one of three pillars in the methodological framework of Value Investing.
Market inefficiencies can cause the Intrinsic Value of a company and its securities to deviate drastically from market prices. This can cause securites to become significantly under- or overvalued. If a security is trading at a large discount to its intrinsic value, it represents a margin of safety for the investor.
Seth Klarman and Margin of Safety
In 1991, Seth Klarman, investment manager of the Baupost Fund, published the book Margin of Safety: Risk-averse Value Investing Strategies for the Thoughtful Investor. In the book, Klarman builds on the concepts put forth by Ben Graham in Security Analysis and The Intelligent Investor,
Protecting against Downside Risk
In his 2011 letter to Third Avenue Value Funds, the late Marty Whitman discussed the concept of Margin of Safety:
I largely disagree with Graham & Dodd as to when low pricing creates a margin of safety. For Graham & Dodd the margin of safety is created mostly by depressed prices in the general market. For Fundamental Finance, the margin of safety is derived largely from micro factors affecting a company and its securities, not general stock market levels. Graham & Dodd seem to have a valid point in terms of guarding against market risk. Fundamental Finance is involved with investment risk, not market risk.
Diversification, quite properly, is key in a Graham & Dodd analysis. It is an OPMI analysis which relies heavily on predicting future earnings and future dividends, something extremely hard to do well. In Fundamental Finance there is much less need for diversification which is viewed in Fundamental Financeas only a surrogate, and usually a damn poor surrogate, for knowledge, control and price consciousness. Non-control investors need a modicum of diversification, but nowhere near to the degree emphasized by Graham & Dodd, MCT and academics in general.
Graham & Dodd is mostly a tool for top-down analysis; while Fundamental Finance, in contrast, is almost completely bottom up. Graham & Dodd describe how to forecast for a coming five to ten-year period:
- Formulate a view as to the general economic climate;
- Anticipate future earnings from the Dow Jones Index and the S&P 500;
- Forecast earnings for individual companies.
In Fundamental Finance, the essential analysis is of the individual company and the current price of the security versus its estimated intrinsic value. Instead of just forecasting earnings, in Fundamental Finance, prognostications are made about:
- Operations;
- Potential resource conversions;
- Access to capital markets.
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