NYU finance professor Aswath Damodaran focuses on myths associated with the concept of “margin of safety” (MOS) in a recent post on his Musings on Markets blog. MOS is thought of as a tool for value investors to protect themselves against uncertainty. Ben Graham brought the term into value investing and Seth Klarman has argued that investors gain the margin of safety by “buying at a significant discount to underlying business value and giving preference to tangible assets over intangibles.” Damodaran lays out the purported benefits of maintaining an MOS, then cautions against being misled by associated myths, as summarized below.
Proponents of margin of safety maintain:
- The value of an asset is always measured with error and investors have to recognize that they can be wrong in their judgments.
- The market price is determined by demand and supply and if it diverges from value, its pathway back is neither quick nor guaranteed.
- MOS will improve your odds of making successful investments.
- MOS will reduce the potential downside on your investments while helping protect and preserve your capital.
Differences in the application of MOS include:
- Valuation basis:
MOS is often defined as the difference between value and price, but investors estimate value differently, such as: through intrinsic value (in its dividend discount model format or a more expansive DCF version), from accounting balance sheets (using unadjusted book value or variants thereof), or off of a pricing multiple (in conjunction with peer group pricing).
- Magnitude and variability:
There seems to be no consensus on what constitutes a sufficient margin, so the follow up question becomes whether it should be a constant or whether it should be greater for some investments than for others.
MOS myths and how to avoid them:
- Myth: Having a MOS is costless:
Reality: 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. Many risk averse value investors would accept this trade off but there is a cost to being too conservative and if that cost exceeds the benefits of being careful in your investment choice, it will show up as sub-par returns on your portfolio over extended periods.
- Myth: if you use a MOS, you can be careless in valuations:
Value investors who spend all of their time coming up with the right MOS and little on valuation are doing themselves a disservice. If your valuations are incomplete, badly done or biased, having a MOS on that value will provide little protection and can only hurt you in the investment process. Remember that you are already double counting risk, when you use MOS, even if your valuation is a fair value, because that value is computed on a risk-adjusted basis. If you are using a conservative value estimate, you may be triple or even quadruple counting the same risk when making investment decisions.
- Myth: the MOS should be the same across all investments:
The investors who use MOS as their risk breakers would not look at companies like the latter, so different investments should evoke different degrees of uncertainty and different MOS.
- Myth: the MOS on your portfolio = MOS on individual investments in the portfolio:
Those who use MOS are skeptics when it comes to modern portfolio theory, but modern portfolio theory is built on the law of large numbers, and that law is robust. Put simply, you can aggregate a large number of risky investments to create a relatively safe portfolio, as long as the risks in the individual stocks are not perfectly correlated. In MOS terms, this would mean that an investor with a concentrated portfolio would need a much larger MOS on individual investments than one who spreads his or her bets across more investments, sectors and markets.
- Myth: the MOS is an alternative risk measure:
To use MOS, you need an estimate of value and there is not any intrinsic value model that does not require a risk adjustment to get to value. In other words, MOS is not an alternative to any existing risk measure used in valuation but an add-on, a way in which risk averse investors can add a second layer of risk protection.