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Investors: Have You Seen Your Margin of Safety Lately?

By Alex Dumortier, CFA - May 4, 2016 at 12:37PM

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Valuation guru Pr. Aswath Damodaran re-visits the key value investing concept of margin of safety (in a market that doesn't present much of one).

Image source: Matt Crampton. Republished under CC BY 2.0.

U.S. stocks are lower in early afternoon trading on Wednesday, with the S&P 500 (^GSPC 3.06%) and the Dow Jones Industrial Average (^DJI 2.68%) (DJINDICES: $INDU) down 0.52% and 0.49%, respectively, at 12:20 p.m. ET. Traders may be digesting Donald Trump's crowning as the Republican party's presumptive nominee after Ted Cruz "suspended" his campaign following his thrashing in yesterday's Indiana primary. Trump would presumably argue that a "Trump discount" is healthy -- last October, he told The Hill that savers were "being forced into an inflated stock market and at some point they'll get wiped out."

Readers of this column will know that I'm big fan of Musings on Markets, the blog of New York University finance professor Aswath Damodaran. Thought-provoking and well written, it's a must-read for even the semi-serious investor.

Yesterday, Damodaran published a post on a concept that Berkshire Hathaway CEO Warren Buffett described as the "cornerstone of investment success": the margin of safety.

Simply put, the margin of safety is the difference between an asset's market price and its (estimated) intrinsic value. It is canonical that a value investor must insist on a margin of safety in order to buy a stock.

With the S&P 500 currently valued at just under 18 times 2016 estimated operating earnings per share -- a level few value-conscious investors would describe as undervalued -- the blog post is a timely reminder of just how important this concept is.

No margin of safety = no margin for error
I'd consider Damodaran a value investor inasmuch as he always considers the difference between a stock's market price and his estimate of its intrinsic value before making an investment decision. However, he tolerates no sacred cows ("I would not put myself in the MOS [Margin of Safety] camp"), exposing five myths value investors have attached to this foundational concept, including:

Myth 1: Having a MOS is costless
There are some investors who believe that their investment returns will always be improved by using a margin of safety on their investments and that using a larger margin of safety is costless. There are very few actions in investing that don't create costs and benefits and MOS is not an exception ... [L]et's categorize type 1 errors as buying an expensive stock, because you mistake it to be undervalued, and type 2 errors as not buying a bargain-priced stock, because you perceive it wrongly to be overvalued. Increasing your MOS will reduce your type 1 errors but will increase your type 2 errors. 

And conversely, if you decrease your margin of safety, you increase your type 1 errors -- buying an expensive stock. That analysis holds whether you are applying it to an individual stock or to an entire asset class. I believe investors have accepted and continue to accept, perhaps unwittingly, lowering their margin of safety (or equivalently their expected returns) with regard to both U.S. stocks and bonds. The result: a greater risk of holding overvalued assets. A lower margin of safety translates into lower expected returns. Buyer beware.

Finally, while we're on the topic of safety, investors (I use the term loosely, here) have been returning to gold again, with the price of the yellow metal breaking $1,300 on Monday to achieve a 15-month high. Perhaps they think the yellow metal has new allure as a safe asset given that perceived geo-political and macroeconomic risks have increased (Trump factor, Brexit in the U.K., etc).

However, nervous investors may want to reflect on the fact that, by definition, there can be no margin of safety in gold. Why? Because it's an asset to which it is impossible to assign an intrinsic value. There's nothing safe about that.

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Dow Jones Industrial Average (Price Return) Stock Quote
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