Why Investing with a 'Margin of Safety' Is Both Low Risk & High Reward - At The Same Time
Why Investing with a 'Margin of Safety' Is Both Low Risk & High Reward - At The Same Time
"Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety." - Benjamin Graham
When most people think of Margin of Safety, they usually think of risk or downside protection. While most investors can agree that downside protection is important, it also invokes interpretations of conservativeness — or worse, cowardice. In a world starved for profits, why would anyone voluntarily play it safe… and earn less in the process?
But what if I told you that that’s not what Margin of Safety means? What if the true meaning behind adopting a Margin of Safety investment approach can result in both Lower Risk & Higher Reward?
But first, how do we recognize when a Margin of Safety exists? The simplest way to observe it is when a stock’s valuations falls to “C’MON MAN” levels. This is where a stock’s price falls by so much relative to its underlying business value that it reflexively makes you go “C’MON MAN!”. You react this way because valuations have fallen to such unbelievable levels that you cannot even conceive it — that’s how you know Margin of Safety exists.
Given how markets tend to be efficient, it’s understandable how some readers might not have experienced this before. However, allow me to demonstrate a few examples from within this newsletter alone where Margin of Safety has existed in abundance before:
(Click stock name to read full stock thesis)
Meta (+220% since) — In Nov 2022, Meta’s share price fell to $90 on fears of Apple’s ad tracking permission changes and Tiktok’s creeping dominance affecting Facebook’s business viability. While I couldn’t have known whether those fears were founded or not, what I did know was that the absolute worst-case valuation for Meta at the time was 24x PE — an absolute steal for the dominant social media platform globally.
SEA Ltd — Last week, I took a look at SEA’s Q2 results and was flabbergasted at their undemanding valuation. It has a fortress balance sheet; and you could assign a 50% margin of safety to their forward earnings twice over — and still come away with a normalized PE of just 12.5x.
Paypal — Fears of transaction margin compression & well-funded Tech megacap competitors on Paypal’s doorstep has led to its share price falling by -80% from its peak. However, the fears here are massively overblown — this is nostalgic to me of Meta in Nov 2022.
Netflix (+130 % since) — In May 2022, Netflix’s share price cratered after it announced a new ad-tier that would disrupt its subscription-based business model. Also, Bill Ackman had recently dumped his stake at a huge loss. However, a cursory analysis revealed that even if all of consensus’s fears came to pass, at worst it would still remain a Top 3 global Streaming company trading at 17x PE.
What’s the common thread that all four of the above stocks shared at the time of their writing? Their share prices had fallen by so much, that I simply could not foresee them staying at those levels forever. In other words, to the best of my ability, I just could not conceive that there was any risk of permanent loss/downside! Discovering these stocks at their valuations at the time truly represented “C’MON MAN” moments for me.
So why is the Margin of Safety approach to investing so powerful? In this article, I’ll explain what took me years to understand — the consummate wisdom of Benjamin Graham crystallized into three words.
“As such, prioritizing a Margin of Safety approach to stockpicking doesn’t even require you to forego maximum upside. It is truly the best of both worlds — you can have your cake and eat it too!”
What Margin of Safety Is And Isn’t
We’ve all heard the above definition of Margin of Safety before — but what does it really mean? To understand what Margin of Safety represents as a cornerstone principle of value investing, the best place to start is what Margin of Safety is NOT.
The namesake of Margin of Safety implies that the investor should leave a “buffer” (or margin of error) from his best estimate of a stock’s fair value before considering it suitable for purchase. For instance, if he thinks that a stock is worth $100, assigning a 20% margin of safety to it would imply that he would only consider buying it if the share price fell to $80 or below.
Of course, in practice adopting a Margin of Safety investment approach does not usually only imply a 20% buffer. Many value investors who champion the Margin of Safety approach interpret its proper application as only buying a stock if it has a 50% or greater buffer from its intrinsic value. This is because a mere 20% buffer doesn’t represent a margin of error — that simply represents standard fare undervaluation. For there to be a margin of “Safety” — where the investor can comfortably expect to breakeven even if the most adverse future scenario materializes — there needs to be a much larger gap between price & value:
As such, investing only when such a large Margin of Safety exists (between price & value) tends to invite interpretations of investor conservativeness (i.e. lower risk). And given the natural inverse relationship between risk & reward, taking lower risk usually implies also accepting lower reward. For instance, a common interpretation of the Margin of Safety investment approach is to have a greater allocation to bonds — which are safer than stocks, but also involve lower yields.
However, this is NOT what a Margin of Safety approach implies to true practitioners of the craft. While such an investment approach does prioritize low risk/downside exposure, it does not automatically resign itself to lower returns/upside exposure. This is because true practitioners of Margin of Safety are not preoccupied with minimizing risk/downside alone — but rather are looking for mispricings to exploit market inefficiencies in risk:reward. (i.e. asymmetric risk:reward)
Allow me to explain further. In efficient markets, share prices tend to somewhat accurately reflect the value of their underlying businesses. This implies that when the underlying business outperforms, share prices go up to reflect that — and vice versa, share prices fall when their underlying business underperforms. Ceteris paribus, the earnings yield of stocks tend to remain roughly the same in efficient markets regardless of circumstances.
However, stock markets are not efficient all of the time. Benjamin Graham’s following quote perfectly encapsulates this phenomenon — “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” Due to the emotional vagaries of mob mentality, greed begets more greed and fear begets more fear — which can result in the market phenomenon of irrational exuberance. This is where investor overexcitement or overpessimism feeds on itself, and spirals share prices ever higher or lower independent of their underlying business value — causing share prices to detach from their fundamental underlying business values. In the context of Margin of Safety, it is when markets are gripped by excessive fear that share prices get driven way below their underlying business value.
Keep in mind that this doesn’t happen in a vacuum — during such times, the value of the underlying business tends to have taken a nosedive first, due to certain fundamental risks materializing (e.g. in Meta’s or Netflix’s case as described above). However, irrational exuberance to the downside manifests when the share prices of said businesses dives even harder — beyond any reasonable floor valuation that even the suffering fundamentals of the underlying business deserves. This can happen when unbridled fearful narratives grip markets, and herd mentality leads to a stampede for the exits — which can result in markets becoming inefficient. If a sufficiently large gap between share prices & underlying business value emerges (e.g. >50%), a Margin of Safety can develop.
Example:$META — Perhaps an illustration of this phenomenon would drive the point home better. When Meta’s share price fell to $90 in Nov 2022, markets were responding to 3 adverse developments within the company: 1) Apple’s new ad tracking permission changes making it more difficult for Meta to target ads on iOS; 2) Tiktok purportedly overtaking Facebook in social media market/attention share; and 3) Zuckerberg’s stubborn commitment to spend $100B on Metaverse CAPEX. While there was quite a bit of evidence that the first two fears were overblown even then, obviously my guess about Meta’s future was as good as anyone else’s.
However, what I was able to personally verify was that even after adding the $100B of budgeted Metaverse CAPEX to Meta’s then-valuation, the worst-case valuation that I could conceivably arrive at was a persistent 24x PE (i.e. based solely on Facebook’s earnings). As someone who was familiar with the inherent moats of Facebook’s platform business, I simply couldn’t fathom how Facebook could only be worth 24x PE into perpetuity. And with all of Facebook’s moats that the same markets had been frothing over just one year prior, I felt that a worst-case valuation of 24x PE was treading into inconceivable territory — i.e. I couldn’t imagine how the risk of permanent loss could exist at that price.
To me, this represented a bona fide mispricing (or “C’MON MAN” valuation) for Meta. Markets had overestimated Meta’s fundamental business risk due to excessive fearmongering, and the rest is history. META 0.00%↑ is up +220% since then.
Notice how in my entire Meta thesis above I didn’t make a single mention of Meta’s potential upside? My entire thesis revolved around how to the best of my ability, I could not estimate any conceivable downside with Meta trading at a worst-case 24x PE. However, this also automatically implied that the stock could be worth at least double what it was trading at the time — i.e. or that at least a >50% Margin of Safety existed. The implication of a 2x upside was automatic — since if a 50% Margin of Safety existed, that meant that the stock could also potentially deliver a 200% return simply by reverting to fair value! (i.e. investors simply recognizing the actual fair value of the stock, without any change in their business fundamentals whatsoever)
Also notice how despite its namesake, the Margin of Safety investment approach as described in the Meta example above automatically implied high returns? Even though my entire thesis was preoccupied with safeguarding my downside, I was also automatically exposing myself to a potential 200% upside… without even trying! This unintuitive phenomenon can exist in stock markets since there is a relative relationship between share prices & underlying business value (i.e. earnings yield remains the same, as described above). Hence, if a >50% relative gap exists between price & value, controlling for investment risk/downside naturally controls for investment reward/upside as well.
This is what I meant earlier when I said that the Margin of Safety investment approach could provide investors with both Low Risk & High Reward at the same time. When it concerns mispriced stocks, the normal inverse relationship between risk & reward breaks down — and thus it becomes possible to find both low risk & high reward in the same stock at the same time. Frequent readers of this newsletter will recognize that I also frequently describe the art of looking for mispriced stocks using another common term — asymmetric risk:reward.
As such, prioritizing a Margin of Safety approach to stockpicking doesn’t even require you to forego maximum upside. It is truly the best of both worlds — you can have your cake and eat it too!
Portfolio Management with Margin of Safety In An Institutional Context
Of course, adopting a Margin of Safety investment approach does come with its tradeoffs. But as we shall see, the tradeoff here is negligible to the value investor — it only involves Time.
Since stock markets tend to be at least somewhat efficient, readers would be correct to assume that such stocks with a >50% gap between their price & value don’t show up all the time. This gives meaning to Buffett’s wisdom of “doing nothing” whenever he can’t find stocks which fit his strict investment criteria. When there are no opportunities with at least a >50% margin of safety, the correct course of action is to sit still & wait until such opportunities reveal themselves — cue Buffett’s analogy of stock markets being a “no-called-strike game”:
However, such longer timeframes are not disadvantageous for the long-term business owner. Value investors tend to look past stock markets and towards the businesses themselves — and fret not about the daily gyrations of prices nor what other people might think about them. What they truly care about is getting a bargain on what they’re buying — in much the same way that shoppers get excited over a limited-time sale — and being among the first to find a stock which sports “C’MON MAN” valuations. I can attest from personal experience that the thrill of such moments can be electric.
Portfolio management with Margin of Safety: However, just because practicing a Margin of Safety investment approach requires long investment timeframes, doesn’t automatically make it inappropriate to be applied in an institutional context — where portfolio performance tends to be measured on a shorter-term basis (e.g. annually/quarterly). Quite the contrary, in fact — such an investment approach actually adds value to the portfolio manager by mitigating short-term portfolio volatility!
The thing about adopting a Margin of Safety investment approach is that there should exist at least a 50% gap between price & value for all positions within the portfolio. This means that the potential downside of all individual positions should be relatively limited (‘floor’) — since their respective share prices are already so woefully undervalued. Conversely, each of their potential upside should also be relatively higher-than-normal (‘ceiling’) — since in an upside scenario grossly undervalued stocks tend to experience a double whammy effect from both fundamentals & multiples recovering at the same time (e.g. Meta above).
Now imagine that you have a diversified portfolio with 20 such stocks — all of which individually have a >50% Margin of Safety. Even though you are not explicitly controlling for macro exposure (i.e. portfolio beta), the inherent Margin of Safety within each stock position helps provide an organic buffer to the overall portfolio’s downside volatility. In any given macro environment, those positions which are expected to underperform should fall by less (due to the ‘floor’ phenomenon as described above) than those positions that are expected to outperform (due to the ‘ceiling’ phenomenon as described above) in the same macro environment — thus resulting in a high Sortino ratio without even trying.
I’ve actually described such a portfolio management style before in the following two articles — so go check them out if you’re curious about the practical details. Also, if you need any further clarification regarding Margin of Safety, please feel free to ask me any questions you might have in the comments section below!
Also check out some of our earlier stock reports!
Good stuff, Aaron.
I might expand this definition to include geopolitical risk in particular, especially with regard to China (but also really relevant elsewhere). On the other hand, depending on who you are, this whole category might just go into the "too hard" pile.
Ben Graham was such a great thinker, and Klarman best encapsulates his deep method of thought and a modern interpretation of "Intelligent Investing", as it were. I have read everything he's written, at least insofar as I can find (including Margin of Safety).
Thank you for the article. Two follow up questions:
(1)
There is a point you raised that I wanted to double-click on:
"I simply couldn’t fathom how Facebook could only be worth 24x PE into perpetuity"
Assuming a 10% discount rate, a 24x multiple implies ~6% perpetual growth rate, emphasis on perpetual. How do you get comfortable with such a valuation given that we're talking about perpetual growth rates? At 6%, Meta's earnings will effectively make up the entirety of the nation's GDP.
It's a bit of a silly argument that I'm making primarily because we aren't capitalizing earnings at a mature state, but my sense is that the 24x multiple alone took you by surprise, and I'm curious to know why.
(2)
How did you quantify the Apple and Tik Tok risks? I'm always worry of risks that turn out to be insignificant in hindsight due to actions taken to mitigate them (i.e., in an alternative universe, these two risks resulted in principal impairment of capital). Going back to Nov. 2022 when Meta traded for $90, what gave you the confidence to underwrite this risk?