The 3 Most Important Words in Investing

The Oracle of Omaha, Warren Buffett, once said that “margin of safety” are the three most important words in investing. But, what exactly is it?

The term, which was popularised by Buffett’s mentor Benjamin Graham in his classic investing tome “Security Analysis”, simply refers to the difference between the price of a business and its intrinsic value. The steeper the difference is, the larger the margin of safety.

For example, if you had determined the intrinsic value of  Company ABC to be at S$6 per share and it is currently trading at S$4, the margin of safety is simply 50%% [(S$6-S$4)/$4 * 100%].

Why it is important

A margin of safety is essential as it allows investors room for error when evaluating a company. Pat Dorsey, the author of “The Five Rules for Successful Stock Investing,” once mentioned:

“Having a margin of safety is critical to being a disciplined investor because it acknowledges that as humans, we’re flawed”.

Furthermore, with a margin of safety, an investor would have already – quote/unquote – made profits as he or she would have managed to buy shares at a discount to its intrinsic business value. By purchasing a share worth S$6 for just S$4, the investor has essentially earned S$2 right from the get-go.

A dollar for 50 cents

The amount of margin required in an investment can actually differ between investors. Some investors would only buy a share for 50 cents on the dollar as they want a 50% margin of safety while others are perfectly fine with a 25% margin. But either way, having a margin of safety is still paramount in investing.

A 50% margin of safety is sometimes hard to obtain in a bull market. However, during a bear market, huge margins of safety are much easier to come by.

During the Great Financial Crisis of 2008-09, Singapore’s share market benchmark, the Straits Times Index (SGX: ^STI), was trading at a price-to-earnings (PE) ratio of around 6 at its trough. When placed in the context of its average PE being around 15 over the past decade, that low valuation translated into a huge margin of safety.

At the individual company level, private medical outfit Raffles Medical Group Ltd. (SGX: R01) can be a good example too. During the depths of the crisis, Raffles Medical’s shares were valued at around 8 times trailing earnings. That compares very favourably against Raffles Medical’s average PE of approximately 25 over the past decade.

The STI bottomed-out at 1,457 points on 9 March 2009. On the same day, Raffles Medical was trading at S$0.78. Today, the STI has more than doubled to 3,341 points while Raffles Medical has gained some 414%. Being greedy when others are fearful pays huge dividends.

Foolish Takeaway

Just like no engineer builds an elevator or bridge without allowing for extra weight, no investor should invest without a margin of safety built into a share’s price. By always thinking in terms of encompassing a margin of safety when investing, investors would do their portfolios a huge favour.

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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 Sudhan P doesn’t own shares in any companies mentioned.