All professions have their own special nomenclature, whether it’s law, medicine, accounting. But one of the most difficult to keep up with is in the investing world. If you spoke with a stock broker or investment analyst 30 years ago, the conversation would have been quite different from what it is today. Then it would have been about fundamentals and earnings trends. Today it would be about alphas and economic value added (EVA). But there is an investment term that has been around for 70 years or so, that probably wouldn’t come up at all. Margin of safety.
Margin of safety is a basic concept that is used in all facets of investment and finance. For example, a bank wants a down payment when you purchase a car or a home, so they have a cushion if their are problems. But rarely today will you hear about margin of safety when it comes to purchasing a stock. And I think that’s too bad. Too much about purchasing stocks ends up being about guessing what’s going to go right, and not considering what the downside will be if things go wrong.
The concept of margin of safety for stocks was developed by Ben Graham in the 1930’s, and was carried forward by his students, which includes Warren Buffett. It’s a simple idea. If a bank wanted to make a super safe loan they’d insist on a 50% down payment. What’s the stock equivalent? A stock that is so undervalued, has so little debt, and so much in earnings that it could weather almost any storm. It’s tough to find stocks like that in the market today after a 24 year bull market. But they are out there, and it’s something you should keep in mind before buying any stock. Ask yourself (as Warren Buffett would) do I have a margin of safety?