The Value in Margin of Safety

The No. 1 goal in investing is to make money ... and hopefully lots of it over a meaningful period of time. But before you can tap the profit spigot, you first have to make sure there aren't any leaks. As a wise person once said, it takes money to make money. 

Preserving capital leads to more capital to preserve
We've all heard Warren Buffett's two rules of investing. First: Don't lose money. Second: Don't forget the first rule. The idea is simple, and the meaning profound. No better example of this loss-aversion exists than the appreciation in Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) stock "since present management took over." For more than 40 years, book value has appreciated by more than 20% a year.

Avoiding losses is the key to making profits in the stock market. And by loss, I mean a real loss of money -- not just a one-day or one-month double-digit percentage decline in share price. In the short term, stock prices will fluctuate. In the long term, a stock's price will ultimately follow the operating performance of the business. You should thus focus your efforts on creating long-term value by carefully choosing good, well-run, attractively priced companies.

All or nothing
The key is to find companies that meet all three of these criteria. If you get the first two right and the last part wrong, you're going to get burned. Google (Nasdaq: GOOG  ) is without a doubt an excellent business; it's one of those rare tech companies, like Microsoft (Nasdaq: MSFT  ) in the 1980s and 1990s, that seems to have a formidable edge that will last for some time to come. The company's management has so far delivered the goods. Unfortunately, this excellent reputation comes at an expensive price. Until the past few months, everyone seemed to think the share price could do nothing but go up. As a result, investors began to think that buying Google at the right price meant buying Google at any price.

As it now stands, Google is off nearly 40% from its high. But even at the current price of $468 or so, the stock is still not a screaming bargain. Sure, the price next year might be higher, but it might not. We're not here to speculate on prices, but rather to protect the downside and let the upside take care of itself. To do this, we look to the most valuable concept in all of investing: the margin of safety.

The three famous words
What is this margin of safety that is so often revered as the "three most important words" in investing? The concept is simple. Suppose you determine that a stock's intrinsic value is $50 a share, and the current market price is $45 a share. While the stock might appear to be trading for less than its intrinsic value, there's a very slim margin of safety. Why? For one, intrinsic value is a moving target derived from a set of assumptions about matters such as cash flow, growth rates, and discount rates. If those assumptions prove wrong, intrinsic value has changed.

As a rule of thumb, many investors look for a 50% margin of safety to account for the fluctuation in intrinsic value (that margin would require a $25-per-share price in the example above). This rule of thumb is not a rigid rule. The quality of the business, strength of the balance sheet, and future growth opportunity all affect the margin of safety. For example, businesses that provide growth at a reasonable rate might command a lower margin of safety, as continuing future growth will serve to increase intrinsic value.

You need it now more than ever
How often have you thought that a stock price was so low that it couldn't go any lower? In today's market, those thoughts have delivered a costly lesson to investors who failed to see the need for a large enough margin of safety. Take First Marblehead (NYSE: FMD  ) , which now sits at less than $5 -- down from more than $40 a share a year ago. Even worse, First Marblehead is down more than 50% since Goldman Sachs (NYSE: GS  ) injected the firm with $1 billion in capital. Additionally, a Goldman fund invested some $260 million for a nearly 17% stake in the company. Yet today, the whole company is valued around $400 million. Time will tell if Goldman's equity investment will prove prudent, but right now it's clear that what seems like a bottom-rung share price doesn't necessarily provide an adequate margin of safety.

The concept behind the margin of safety is to reduce the likelihood of damaging losses if certain valuation assumptions go wrong. With plenty going wrong today in most corners of the market, you need a wide margin of safety more than ever. If you choose to invest in financials, I would demand an even greater degree of margin of safety than ever before. As these companies continue to raise capital via equity sales, existing stockholders will face dilution and as a result, intrinsic value will head south.

In this market, preservation of capital is the name of the game. Believe it, Fools.  

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