Margin of Safety: An alternative risk assessment tool?

April 19th, 2011
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Contributed by: Aswath Damodaran
I have lost count of the number of times I have been taken to task for not mentioning "margin of safety" in my valuation and investment books. In general, the critique is usually couched thus: "Instead of using beta or some other portfolio theory risk measure, why don't you look at the margin of safety?" While I see the intuitive value of paying heed to the "margin of safety", I don't see the two as alternative measures of risk. In fact, I think that risk measures in valuation and margin of safety play very different roles in investing.

I know that "margin of safety" has a long history in value investing. While the term may have been in use prior to 1934, Graham and Dodd brought it into the value investing vernacular, when they used it in the first edition of "Security Analysis". Put simply, they argued that investors should buy stocks that trade at significant discounts on value and developed screens that would yield these stocks. In fact, many of Graham's screens in investment analysis (low PE, stocks that trade at a discount on net working capital) are attempts to put the margin of safety into practice.

In the years since, there have been value investors who have woven the margin on safety (MOS) into their valuation strategies. In fact, here is how I understand how a savvy value investor uses MOS. The first step in the process requires screening for companies that meets good company criteria: solid management, good product and sustainable competitive advantage; this is often done qualitatively but can be quantifiable. The second step in the process is the estimation of intrinsic value, but value investors are all over the map on how they do this: some use discounted cash flow, some use relative valuation and some look at book value. The third step in the process is to compare the price to the intrinsic value and that is where the MOS comes in: with a margin of safety of 40%, you would only buy an asset if its price was more than 40% below its intrinsic value.

The term returned to center stage a few years ago, when Seth Klarman, a value investing legend who runs The Baupost Group, wrote a book using the term as the title, published in 1991. In the book, though, Seth summarizes the margin of safety as "buying assets at a significant discount to underlying business value, and giving preference to tangible assets over intangibles". Seth is a brilliant thinker (I love the letters he writes to investors) and the book has original and interesting ways of looking at risk. I learned a great deal about the ethos of value investing but it did not alter the fundamental ways in which I approached estimating intrinsic value, only the ways in which I used that value.

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The Baupost Group
Related People: George Rizk; Seth A. Klarman
Related Entities: Baupost Capital; Baupost Fund; Baupost Group Inc, Baupost Group LLC; Baupost Value Partners; BSP Partners; Margin of Safety; Margin of Safety
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