The secret of Warren Buffett’s extraordinary success comes from his basic rule in investing: never lose money. Despite the simplicity of this rule, many Warren Buffett followers still find themselves losing money year after year. The reason is that many of these followers have forgotten the magic words of capital preservation: Margin of Safety
What is Margin of Safety? The term “Margin of Safety” was coined by Ben Graham in his seminal book, The Intelligent Investor. The idea is that an investor should only buy a stock when his calculated stock value is significantly higher than the prevailing market price.
The difference between the calculated stock value and the market price is your margin of safety, expressed in percentages. This “allowance” gives you cushions against miscalculation of the business value, bad luck and unexpected events. There’s no hard and fast rule on how much Margin of Safety is needed before you can buy the stock. It depends on how comfortable you are with the company.
For companies that have strong brand names and balance sheet, a margin of safety of 25% is enough. Conversely, you need a higher margin of safety for companies that have truck loads of debt and in dire financial position.
Let me give you a theoretical example.
Suppose you were looking at the 52-week low list and realized that your favorite stock, Bravo Corp. was on the list. You began to investigate the cause why a global franchise such as Bravo Corp. was punished by the stock market. After reading the news, you found out that the CEO’s resignation caused the decline of the share price.
You read the latest annual report and sorted through the different financial reports. You concluded that there is nothing wrong with the stock. In fact, you saw a tremendous growth in international operations.
You calculated its business value and it’s worth $100 a share. With the current stock price at $75 a share, your margin of safety is $25, or equivalent to 25%.
If you are comfortable with a 25% margin of safety, you can go buy shares of Bravo. After all, there is a good reason to scoop up Bravo Corp. shares – a global franchise and good prospects abroad.
One more thing about this concept is that an investor should focus on the risks before looking at the potential upside of an investment. If the risk-to-reward ratio is higher than normal, you should consider making a “pass” on the investments.
Once you have protected your downside, the upside will follow. In investing, capital preservation is more important that capital appreciation.