Margin of Safety

A tenet of investing which value investors practise. A value investor would estimate a company’s intrinsic value via some model, and then try to purchase the stock when it is trading at a price below the intrinsic value by a certain discount. Conservative investors may seek a discount of 20% while others may be satisfied with 10%. An investor would demand a margin of safety because his estimate of the company’s intrinsic value may be wrong and the future has a certain level of unpredictability.

A value investor believes that stocks do trade at large discounts to intrinsic value at times due to the irrationality of the markets, giving them a good opportunity to buy something good at a discount with a safety cushion.

An old Chinese saying goes “When a sculptor sculpts the eye, he makes it smaller at first so he can make it bigger later if needed;when he sculpts a nose, he makes it bigger at first so he can whittle it smaller if needed.” It is a good summary of what margin of safety means to investors.

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