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, 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.
The basic idea behind MOS is an unexceptional one. In fact, would any investor (growth, value or a technical analyst) disagree with the notion that you would like to buy an asset at a significant discount on estimated value? Even the most daring growth investor would buy into the notion, though she may disagree about what to incorporate into intrinsic value. To integrate MOS into the investment process, we need to recognize its place in the process and its limitations.
Stage of the investment process
Note that the MOS is used by investors at the very last stage of the investment process, once you have screened for good companies and estimated intrinsic value. Thinking about MOS while screening for companies or estimating intrinsic value is a distraction, not a help.
Proposition 1: MOS comes into play at the end of the investment process, not at the beginning.
MOS is only as good as your estimate of intrinsic value
This should go without saying but the MOS is heavily dependent on getting good and unbiased estimates of the intrinsic value. Put a different way, if you consistently over estimate intrinsic value by 100% ore greater, having a 40% margin for error will not protect you against bad investment choices. That is perhaps the reason why I have never understood why MOS is offered as an alternative to the standard risk and return measures used in intrinsic valuation (beta or betas). Beta is not an investment choice tool but an input (and not even the key one) into a discounted cash flow model.
In other words, there is no reason why I cannot use beta to estimate intrinsic value and then use MOS to determine whether I buy the investment. If you don’t like beta as your measure of risk, I completely understand, but how does using MOS provide an alternative? You still need to come up with a different way of incorporating risk into your analysis and estimating intrinsic value. (Perhaps, you would like me to use the risk free rate as my discount rate in discounted cash flow valuation and use MOS as my risk adjustment measure… That’s an interesting choice and worth talking about … I know that Buffett claims to do something similar, but he discounts only the cash flows that he believes he can count on, making his cash flows risk adjusted cash flows.)
I know.. I know… There are those who argue that you don’t need to do discounted cash flow valuation to estimate intrinsic value and that there are alternatives. True, but they come with their own baggage. One is to use relative valuation: assume that the multiple (PE or EV/EBITDA) at which the sector is trading at can be used to estimate the intrinsic value for your company. The upside of this approach is that it is simple and does not require an explicit risk adjustment. The downside is that you make implicit assumptions about risk and growth when you use a sector average multiple… The other is to use book value, in stated or modified form, as the intrinsic value. Not a bad way of doing things, if you trust accountants to get these numbers right…
Proposition 2: MOS does not substitute for risk assessment and intrinsic valuation, but augments them.
Need a measure of error in intrinsic value estimate
If you are going to use a MOS, it cannot be a constant. Intuitively, you would expect it to vary across investments and across time. Why?
The reason we build in margins for error is because we are uncertain about our own estimates of intrinsic value, but that uncertainty is not the same for all stocks.
Thus, I would feel perfectly comfortable buying stock in Con Ed, a regulated utility where I feel secure about my estimates of cash flows, growth and risk, with a 20% margin of safety, whereas I would need a 40% margin of safety, before buying Google or Apple, where I face more uncertainty. In a similar vein, I would have demanded a much larger margin of safety in November 2008, when macro economic uncertainty was substantial, than today, for the same stock.
While this may seem completely subjective, it does not have to be so. If we can bring probabilistic approaches (simulations, scenario analysis) to play in intrinsic valuation, we can not only estimate intrinsic value but also the standard error in the estimates.
Proposition 3: The MOS cannot and should not be a fixed number, but should be reflective of the uncertainty in the assessment of intrinsic value.
There is a cost to having a larger margin of safety
Adding MOS to the investment process adds a constraint and every constraint creates a cost. What, you may wonder, is the cost of investing only in stocks that have a margin on safety of 40% or higher? Borrowing from statistics, there are two types of errors in investing: type 1 errors, where you invest in over valued stocks thinking that they are cheap and type 2 errors, where you don’t invest in under valued stocks because of concerns that they might be over valued.
Adding MOS to the screening process and increasing the MOS reduces your chance of type 1 errors but increases the possibility of type 2 errors. For individual investors or small portfolio managers, the cost of type 2 errors may be small because there are so many listed stocks and they have relatively little money to invest. However, as fund size increases, the costs of type 2 errors will also go up. I know quite of few larger mutual fund managers, who claim to be value investors , who cannot find enough stocks that meet their MOS criteria and hold larger and larger amounts of the fund in cash.
It gets worse, when a MOS is overlaid on top of a conservative estimate of intrinsic value. While the investments that make it through both tests may be great, there may be very few or no investments that meet these criteria. I would love to find a company with growing earnings, no debt, trading for less than the cash balance on the balance sheet. I would also like to play shortstop for the Yankees and slam dunk a basketball and I have no chance of doing any of those and I would waste my time and resources trying to do so.
Proposition 4: Being too conservative can be damaging to your long term investment prospects.
So, let’s call a truce. Rather than making intrinsic valuation techniques (such as DCF) the enemy and portraying portfolio theory as the black science, value investors who want to use MOS should consider incorporating useful information from both to refine MOS as an investment technique. After all, we have a shared objective. We want to generate better returns on our investments than the proverbial monkey with a dartboard… or the Vanguard 500 Index fund…
Aswath Damodaran serves as Chairperson, Institute for Social and Economic Change, Bangalore. He served in the Indian Administrative Service for over 37 years and retired as Chief Secretary to the Govt of Karnataka.
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