Margin Of Safety – Your Safety Valve Against Disaster
Hedge fund manager Seth Klarman published the book Margin of Safety in 1991. It was printed in 5,000 copies and never printed again. Later in the 90s it got a boost and has since gained a loyal following, almost like a cult.
The message of the book is simple: Avoiding capital loss is the most important thing for an investor.
To manage this, a discount or a safety margin is essential. Investment depends on a very uncertain future and all investors make mistakes. Therefore, you need to have a margin for such errors to minimize losses.
Hobby investors in particular are concerned about how much they can earn and rarely think about how much they can lose if the investment goes wrong.
It is almost impossible to know where the stock market is in the future, stocks go both up and down a lot, and therefore you should analyze what you think the company is throwing away during x number of years and assess the safety margin based on that.
The safety margin is unfortunately not an exact science, and to know the margin requires a starting point and a value of the company.
According to Klarman, to find the value of a company, it is best to use the present value method. The present value method is the sum of future free cash flow adjusted for a discount rate.
It is not the book’s syllabus to explain this model, but it is recommended to read more about it via online searches.
A simpler method than the present value method is to look at the historical values of the company.
What has the price in relation to profit and cash flow been in the past (P / E and P / CF)? Is the company traded at a premium or discount in relation to this?
For example, if the stock is overvalued by 15% in relation to historical multiples, what does it mean for the return if the company is traded at historical multiples in ten years (ie a reduction in P / E of 15%)? Are today’s multiples a good enough safety margin?
The recently deceased Jack Bogle, the man behind the management company Vanguard and a champion of passive equity funds, thought the expected return must be calculated in a very simple way. The simpler the method, the less likely it is to make a mistake.
Let’s try understanding this with an example. Today’s dividend yield is 3%, future annual growth in earnings per share is expected to be 7% and P / E in ten years is expected to increase from 15 to 18.
This means that the annual return is 10% from dividends and earnings per share (3 + 7) and approximately 2% from the multiple expansion from 15 to 18.
In total, it gives an expected 12% annual return. If you expect the P / E to fall from 18 to 15, it gives an approximately 8% annual return (3 + 7-2).
The latter point shows what a reasonable safety margin entails: if you pay too much for the company’s profits, the return sometimes falls very much.
Bogle’s strategy is based on dividend shares and that you also invest in companies where you can calculate future dividends with a degree of certainty. Logically enough, you then only have to deal with “quality shares”.