When investing, it is well accepted that one of the main things you should focus on is risk. However, modern investment theory mainly focuses on the volatility of an asset in its treatment of risk. The margin of safety theory is a little different - it argues that downward spikes of volatility make stocks less risky. This is an important concept to grasp in depth, because common risk theories can lead to missed opportunities. Investing gurus Benjamin Graham and Warren Buffett were instrumental in developing margin of safety. Read on to find out how this theory helped propel their portfolios to meteoric heights.

SEE: Beta: Gauging Price Fluctuations

Beta's Misgivings
In general, people do not like surprises. More precisely, people do not like adverse surprises. Because investors are assumed to be more averse to losing money than gaining it, modern investment theory views the volatility of an asset, as measured by its beta, as the main component of risk. The theory implies that investors should pay less for an asset with a higher beta.

One problem with beta is that it implies that if an asset's value suddenly drops, even due to irrational market behavior, that it becomes more risky because it will have a higher beta. We'll poke some holes in this view in moment, using an example from Warren Buffett.

An Alternate Strategy of Risk
Introduced by the father of value investing, Benjamin Graham, and notably implemented by Warren Buffett, margin of safety was presented as a different view of risk and how to protect against it. Graham's concept is not new. He first presented his investing style with David Dodd in 1934's "Security Analysis" and later with his more accessible book, "The Intelligent Investor", which was first published in 1949.

SEE: The Intelligent Investor: Benjamin Graham

Graham characterized volatility as "Mr. Market" coming each day to buy from you or sell to you. Graham hoped to buy assets that Mr. Market would sell to him with a 50% margin of safety. This, essentially, would be like trying to buy a dollar for $0.50.

Graham discussed how companies all have an intrinsic measurable value. When Graham first pitched and practiced this idea, information on companies was not nearly as easy to access. He would search through the financial statements and look for what he called net-nets, or companies trading below their liquidation values.

Graham would take a company's current assets with considerable deductions, and subtract all of the liabilities on the balance sheet. At its heart, Graham's net-net investing is the most conservative value approach, and involves very little risk if done right.

SEE: 12 Things You Need To Know About Financial Statements

Example - Finding A Company\'s Net-Net
ABC Company has the following balance sheet and market capitalization:
Cash $250
Cash Equivalents $50
Accounts Receivable (A/R) $100
Inventories $100
Total Liabilities $300
Share Price $62.50

Cash and cash equivalents are good to go, we have $300 there. Next, we turn to A/R, some of which will not be paid. Usually we have a net A/R number on the balance sheet, indicating the amount of receivables the company expects to recover. If we have it, this net number is based on the company's history of collecting receivables, and is a good indicator, but we would still discount it a little for added safety.

In this scenario, we have a gross A/R number. Again we don't expect to recover it all, but ABC is known to have a fairly reliable client base and we could easily anticipate recovering around 80% of A/R - to be even more conservative we will only factor in recovering 75%. Many investors may want to take a look at the company's allowance for doubtful accounts in their financial statements as a method for gauging an accurate recovery percentage, but in this case, we'll value A/R at $75 ($100 x 0.75). Finally, there is ABC's inventory. ABC has competitors, which we could assume, at the very least, would buy the inventory for half its value. So we take the inventory's value at $50 ($100 x 0.5).

We end up with marked down current assets of $425 ($300 + $75 + $50), and total liabilities of $300. This net-net is worth $125 ($425 - $300), not even accounting for any real estate or other long-term assets the company might have. With the company selling at only $62.50 in the market, this is a net-net with a 50% margin of safety. Paying half of a company's net-net value was Graham's goal, and at most, he would pay two-thirds of a company's net-net value, for a 33% margin of safety. In our example, we have a 50% buffer between the market value of the company and our conservative valuation of the company's current assets. By only buying at a steep discount to our valuation, this margin of safety provides its own built-in measure against the risk of mistakes in our calculations.

SEE: Volatility's Impact On Market Returns

Let Volatility Be Your Friend
This process of investing did not guarantee success, but with research and hard work, finding one of these scenarios was about as close to a sure thing as you could get. A lot has changed, and Graham's net-nets have essentially disappeared in the modern market. With the quick and widespread dissemination of information, markets have become somewhat more efficient.

While net-nets are disappearing, investors can see that the market provides sales on assets quite often. The concept of buying companies with an adequate margin of safety still remains, and has been practiced with great success by many value investors, most notably Warren Buffett.

Example - Taking the Value of Long-Term Assets Into Account
In the ABC example, we gave absolutely no value to the company\'s long term assets. Let\'s return to the example and suppose that that the company\'s share price is now at $200. We calculated its net-net worth at $125, so according to that it would not be a good value, but we note that ABC also has the following assets on its books:
Plant, Property, & Equipment $200
Long-Term Bonds $100

We notice from some research that the plants on the company's balance sheet have likely appreciated because property values have gone up in that area. However, we will remain very conservative in this example and still value it at $200. Next, with the company's long-term bonds, we may worry about the market value if the bonds need to be sold quickly. We will only accept 75% of the value, and value the bonds at $75 ($100 x 0.75). We end up with an asset value of $400 (net-net worth of $125 + $200 + $75). Again, we can buy the stock of this company with a 50% margin of safety at its current market price of $200.

This again seems like a home run of an investment. We are still being conservative, and we ignored any assets that could be off ABC's books, such as the appreciated value of its real estate. Other hidden assets are brands, exceptional management, competitive advantages, etc. There is much to be said about the market value of hidden assets, but the point will remain the same.

Don't Run From Beta
Now looking strictly at beta, let's say ABC had a beta of 1.5. After all of our work, we decide to go to bed and buy tomorrow. However, the next day, "Mr. Market" decides to take the price of ABC down to $150, while the rest of the market stays pretty flat. This sharp 25% decline in ABC stock makes it riskier according to beta.

However, according to Warren Buffett in his 1993 letter to shareholders this altered perception of risk is misleading:

"Under beta-based theory, a stock that has dropped very sharply compared to the market - as had Washington Post when we bought it in 1973 - becomes "riskier" at the lower price than it was at the higher price. Would that description have then made any sense to someone who was offered the entire company at a vastly-reduced price?"

What this means is that volatility is our friend in this scenario. We did the work to value the company, and now Mr. Market is just offering it to us at a steeper discount and a higher margin of safety. If we had already made the purchase before the decline, we might kick ourselves for bad timing, but according to our research, an investment in ABC is still worth much more than what we paid.

SEE: Beta: Knowing The Risk

Take a Page From the Masters
The concept of margin of safety as practiced by Warren Buffett is not that complicated. These are fairly simple ideas, and should teach us all not to rely simply on volatility as a judge of risk. Many common theories of risk make volatility out to be a bad thing, and if a stock's sea becomes choppy, some investors may sail for calmer waters. But take a cue from Warren Buffett. He, and other value investors, get excited in volatile and down markets. If you invest carefully, and with an adequate margin of safety, Mr. Market's mood swings can lead to great opportunities.

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