Margin Of Safety Stocks

By Sham Gad | July 06, 2010 AAA

The margin of safety is considered the cornerstone of any successful investment approach; for value investors, it's the gospel. Unfortunately many more people can say the phrase than truly put it into practice. The result is a lot of expensive and potentially avoidable investment mistakes.

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A Big Myth
Many consider Warren Buffett the greatest investor in modern times. His record speaks for itself. But even Buffett has had his share of investment mistakes over the years. That said, he's made fewer mistakes than many and his successful bets are some of the most spectacular ever recorded. Buffett's Berkshire Hathaway (NYSE: BRK.A, BRK.B) has shown book value per share appreciation of 20% per year for more than 40 years! And that's despite any mistakes Buffett may have made. The fact is that not even Buffett himself is a perfect investor, and although mistakes may be inevitable, whether they'll sink an investor's portfolio is less certain. (For more, see Warren Buffett: The Road To Riches.)

The concept of a margin of safety centers around the understanding that investing is not a perfect science. It's a painfully simple concept. Suppose you are building a bridge that during full traffic might to subject to 100,000 pounds of weight. Any rational bridge builder is not going to build a bridge with a weight limit of 100,000 or even 110,000 pounds. Instead the bridge will be built to hold 150,000 pounds or more.

Bridges and Stocks
The lesson here is to approach investing in equities like a bridge builder. For example, a business like grocer Winn Dixie (Nasdaq:WINN) looks like a bad investment as the stock price continues to languish. Indeed, grocery retail is a tough business with a lot of strong competition from bigger and financially stronger names like Wal-Mart (NYSE:WMT) and Costco (Nasdaq:COST). Yet Winn Dixie shares trade at $9, have a book value of $16 per share and net cash of over $3 per share. The business is profitable and continues to improve its operations. Under this scenario a decline in the share price should not be of any great concern.

This is because of the margin of safety provided by the strong balance sheet and stability of the business. If Winn Dixie were to liquidate today, there is a very high probability investors would get more than the current stock price. So in essence, one is getting the future growth and operational improvement for free. That's not the case with Kroger (NYSE:KR), which trades for more than two times book value and has more than $7 billion in net debt against its market cap of $13 billion. Even if Kroger's a good company, the current valuation provides no margin of safety for its shareholders. (For more, see Take On Risk With A Margin Of Safety.)

Look for Erosion
Back to our proverbial bridge; over time wear and tear may diminish the weight capacity of the bridge, just as with a business, a sustained period of poor performance, poor management or the like can reduce or even eliminate a company's margin of safety. It's always up to the investor to periodically examine the performance of a business to determine if any major setbacks have affected the initial investment analysis. If so, then the margin of safety has changed as well. All in all, the selection of quality stocks with a high safety margin is more likely to produce highly favorable results for the patient investor. (For more, see The Value Investor's Handbook.)

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