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One of the Most Important Concepts in Investing – The Margin of Safety

After recently re-reading one of the all-time investment classics Margin of Safety written by Seth Klarman, I remembered where I first encountered the investment concept of a “margin of safety”.

And funnily enough, it was from one of my engineering textbooks (I have an engineering background, by the way).

Basically, when an engineer designs a bridge to withstand a 10 tonne truck, he will need to add in a margin of safety, maybe around 50% or so, to ensure that the bridge can withstand a load of at least 15 tonnes. The idea seems so logical and sensible if you think about it: Would you dare to travel on a bridge that might fail right at the maximum load it is supposed to support?

The Importance of Margin of Safety

As logical as the concept of a margin of safety is, few actually apply it in the world of investing.

For those who believe in the idea of value investing (like me!), a margin of safety is the core concept underlying the philosophy. The concept was popularized by Benjamin Graham, the father of value investing, and here’s how it works.

When it comes to investing in shares, Graham believed in a systematic approach that emphasized the study of a company’s fundamentals. Through the application of Graham’s systematic approach, investors would then be able to come up with an estimated “intrinsic value” of a company.

After that however, investors shouldn’t head out to purchase shares that are selling for just a tiny bit below their estimated intrinsic value. No. To Graham, investors should only make an investment if the share was selling at a price that is a long way below its intrinsic value.

For instance, if we have calculated the intrinsic value for Olam International (SGX: O32) to be S$4 billion, it is still unwise for us to invest in it if the company can be bought for just S$3.47 billion at its current market capitalisation.

Before we invest, we should always apply a margin of safety to our valuation or target price. So, if we estimate the company in question to be worth S$4 billion we might only invest in it if it can be bought at say S$2 billion or less with a margin of safety of at least 50%.

Put another way, if we now assume that Jardine Cycle & Carriage (SGX: C07) is currently trading at its fair value at its latest price of S$35.92 a share, buying it during the Great Financial Crisis of 2007-2009 when it was selling just above S$8 a share at its lowest would have given us a margin of safety of more than 70%.

All told, the concept of a margin of safety is something we can use to minimize our downside risks in investing and it can be applied to any stock, even to the Straits Times Index (SGX: ^STI) itself through its index trackers.

With a margin of safety, even if we are wrong in our valuation work, we would still have some cushion before any losses can occur as we would have bought shares at a much cheaper price.

Foolish Bottom Line

Understandably, applying this concept might restrict us from investing in many of the 700+ companies listed in the Singapore Exchange. However, we don’t need all 700 companies; we only need to find a small handful of companies to invest in to create a truly diversified portfolio.

Furthermore, as billionaire investor Warren Buffett has famously pointed out, “Rule number 1 in investing is never lose money, and rule number 2 is to never forget rule number 1.” Adhering to the concept of margin of safety might just keep us from breaking both rules.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.