In the previous whitepaper, we discussed calculating the intrinsic value of holdings, allowing investors to make better buy, hold, or sell decisions. However, the next step after finding the intrinsic value is determining the Margin of Safety of your holdings. Using the Margin of Safety, investors can buy a company at a market value much less than its intrinsic value, which can reduce risk and improve return simultaneously.
Credit:Samco
The concept of Margin of Safety was first introduced by the renowned value investor Benjamin Graham and his pupil Warren Buffet. It was soon popularized as investors find it effective as a cushion against errors in analyst judgment or calculation. As Warren Buffett says: “You don’t try to buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And that same principle works in investing.”
The Margin of Safety is essentially a buffer zone for human error, bad luck, or unexpected events such as Covid-19. Take the McDonald’s store from our previous whitepaper, for example. We valued the store to be around $5.1 million, and the store will be sold at the end of year 5 for $1,000,000.
If an investor buys the store at $4.5 million and all assumptions are accurate, they will get a 15% return after five years. The return is calculated by adding all the future cash flows that are discounted at the proper rate, subtracting the cost of the store, and divided by the cost of the store.
However, the return may decrease if significant changes happen in the future that affect the store’s profitability or the neighborhood in which the store is located. For example, if people move out of the neighborhood around the store due to unexpected policy changes, and five new fast food restaurants with lower prices are built near the McDonald’s store, the assumption would completely change. As customers decrease, the store could shrink at -30% annually. The valuation of this store would change as well.
Worst Case Scenario
If the investors bought the store at $4.5 million, they would’ve experienced a 36% loss.
However, suppose they use the Margin of Safety of 50% and buy the store for around $2.5 million through a bargain. In that case, the investor will still profit and make around a 14% return on investment even if the pessimistic scenario plays out.
If everything is held steady and the optimistic scenario occurs, the investor will make a 106% return on the investment, almost ten times the return if they buy the store at $4.5 million.
The Margin of Safety is often calculated by utilizing the market price as a point of comparison, and depending on risk preferences, it can vary among investors. In the previous example, the Margin of Safety is derived from the following equation
A Margin of Safety of 50% can be considered to be very safe as it is very difficult for any high-quality business to lose more than 50% of its value. If a business is making $100 million each year, losing more than 50% of its value means that the business is only making $50 million or less each year throughout its lifetime.
A 30% shrinkage in the previous example only led to a 44% decline in the store’s intrinsic value. Under this situation, the investor would still make money if they buy the store with a Margin of Safety. Therefore, it is very unlikely for a high quality business to lose half of its intrinsic value. Thus, risk-averse investors should always strive for a 50% margin of safety when analyzing new potential investments.
Furthermore, once the stock reaches its deemed margin of safety investors should be cautious about the reasoning behind the drop. For example, many tech stocks have taken an unfair beating in the current market correction due to mass psychology. Investors are moving their positions from tech to other sectors like energy because everyone else is selling their positions in tech, scaring away more investors. Nevertheless, many of these tech stocks have not changed in any way fundamentally.
This would be a special opportunity for intelligent investors who understand that the long-term demand in the tech market has not changed and the current short-term fluctuation is temporary. However, suppose the company’s price drop is driven by permanent, fundamental change such as emerging competitors, an adjustment in government regulations, or a complete change of management team. In that case, the short-term fluctuation would not be temporary.
In conclusion, investors can be certain to achieve the Margin of Safety by buying businesses at a significant discount to their intrinsic value, and understanding the reasons behind the declines in a given stock price. In the next article, we will discuss the final task in surviving the bear market: strategizing with your financial advisors.
By Siddharth Singhai
Disclaimer:
This White Paper expresses the views of the author as of the date indicated and such views are subject to change without notice. Ironhold Capital has no duty or obligation to update the information contained herein. Further, Ironhold makes no representation, and it should not be assumed that past investment performance is an indication of future results. Moreover, wherever there is the potential for profit there is also the possibility of loss.
This White Paper is being made available for educational purposes only and should not be used for any other purpose. The information contained herein does not constitute and should not be construed as an offering of advisory services or an offer to sell or solicitation to buy any securities or related financial instruments in any jurisdiction. Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. Ironhold Capital Fund 1, L.P. (“Ironhold”) believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based
