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Buffett Principles: Margin of Safety

Value investor with a deep passion for understanding and a desire to improve results over time.


A Core Principle

Warren Buffett's letters to shareholders reveal that Buffett can be a professor at times, simplifying arcane financial concepts like interest rates and intrinsic value so that a student (reader, shareholder) can understand them on a fundamental level. He can also be a preacher of sorts, evangelizing relentlessly to stay calm and keep investing, and delivering the most important elements of his sermons week after week (letter after letter). One of the ideas Buffett both preaches and teaches the most about is margin of safety (sometimes abbreviated as MOS), the idea that you can never really be sure about intrinsic value.

Value Investing is Analytical

You're thinking: wait a second! Value investing involves mathematical calculations and percentages. Why would you need a margin of safety—an indication that you don't really have as good of an idea as it might otherwise seem—if this is just a math problem? Can't smartphones do billions of math problems every second?

Ben Graham first used the phrase "margin of safety" when he wrote 1934's monumental Security Analysis. In the book, Graham recognizes that investing necessarily involves uncertainty. You simply can't know everything there is to know about a security (stock or other investment), but even understanding that your guess about intrinsic value isn't going to be precise can be useful. However, you can do one better: estimate an uncertainty range based on your familiarity with the company, sector, stock, or some combination of all three.

Ben Graham coined "margin of safety" in 1934

Ben Graham coined "margin of safety" in 1934

One Question

One way to classify the stocks you're following is by familiarity. The question you're trying to ask yourself is:

How confident am I in my projections of future cash flows coming in to this company?

Sounds simple, right? Well, not so fast. We need to remember that "future cash flows" can entail an enormous number of variables. The Fed might raise interest rates next year; what happens to your company's ability to borrow money if they do? If they're hanging on by a debt-thread, you might factor in a much higher margin of safety, especially if you're unsure about those future interest rates.

You also need to consider the company itself, of course. Is it a well run company? Does it have an economic moat? What's the management like?

Keep in mind that macro headwinds, especially across a sector, can cause even a great business to have a really rough few years. This can also cause a stock's price to stay very low for a very long time.

Buckets of Confidence

Ultimately, you need to divide your stock universe into buckets of confidence. Think in terms of at least three distinct groups:

  • Top tier - A grade (great businesses that are well run and have solid earnings prospects that you understand how to price it reasonably well). Margin of safety: 10-25%.
  • Middle tier - B grade (either you understand the business and how to price it, but it’s not on sale; or it looks cheap but you're not as confident). Margin of safety: 25-50%.
  • Bottom tier - C or below (don’t understand well and don’t think it’s super cheap right now). Margin of safety: 51%+.

These are just arbitrary examples, but having a useful framework like this is the general idea. Put simply: the more uncertain you are about the future returns of the business, the higher margin of safety you should assign.

Take Action

Once you have your baskets, it's probably time to set price targets (alerts that will let you know when a stock's price reaches a preset level), or at least to keep a record of what you think the intrinsic value is, with your margin of safety taken into account. That's your target buying price, at least for an entry point. Consider buying in tranches from here; if your stock reaches the level at which you think it's a bargain, buy a chunk of the total amount you'd be comfortable owning, but not all of it. Instead, wait for another 10% drop, then buy another chunk, and so on.

Baskets like this are incredibly useful if you're following more than a handful of stocks. My own brain insists on following 50-75 companies, but that number might be a lot lower for you (or even higher). Regardless, classifying those companies into manageable groups so that you know exactly what to do when the time comes that the price drops can help you make better, more consistent investing decisions.

This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.

© 2022 Andrew Smith