Investing is far from a perfect science. Too often, investors let their emotions get in the way of their success. While it might seem like the most logical strategy as an investor is to buy when the market is doing poorly and sell when it’s doing well. Instead, the historical data shows that the opposite happens. Investors tend to buy when the market is returning promising numbers. When the market is shaky though, investors are fearful and want to sell as much as possible to reduce their risk. We call this getting stuck in the cycle of fear and greed.

The key to success as an investor, then, is to undertake investing without letting emotions get in the way. To do this, there are a few guiding principles you can follow that can help you make smart choices. One of those is the Margin of Safety.

Margin of Safety

First used widely by Benjamin Graham, who’s known as the “father of value investing,” according to Investopedia, and his followers like Warren Buffet, the margin of safety refers to the difference between a security’s market price and its intrinsic value as estimated by a particular investor. This margin of safety enables the investor to purchase the securities during a period of time that provides only minimal risk. Though the margin of security isn’t a guarantee of an investment that is successful, it does provide a cushion in the event that errors are made.

It’s important to know how the margin of safety doesn’t guarantee an investor’s success and how it provides room for miscalculations. Determining a security’s intrinsic value is calculated differently based on an investor’s particular method which is just as likely to be correct as it is to be incorrect. One way of determining intrinsic value is to look at the quantitative and qualitative aspects of a company such as an analysis of its financial statements, as well as its business model, ratios and target market factors. A valuation method called the discounted cash flow model studies the weighted average cost of the business’ capital and its free cash flow. These provide its time value of money.

Value-Based Investing Strategy

An investor (or registered investment advisor) who applies a margin of safety is practicing a value-based investing strategy. In other words, the investor seeks out those stocks that are believed to be undervalued by the market thus far. At the heart of this strategy is the thought process that the market tends to overreact to the news — good or bad — with price movements that typically don’t correspond to the company’s quantitative and qualitative information. This discrepancy provides savvy investors with the option to buy when the security’s price is low.

As noted previously, investors often act irrationally. They purchase a stock that is valued highly because they think they are missing their next opportunity to create wealth. On the other hand, an investor that is holding a security that has a price-to-book ratio that is lower than expected feels compelled to sell it because they believe it will continue its downward spiral.

Investors who are able to select those stocks that have a high intrinsic value — in spite of the company’s declining shares — can profit from this emotionally-driven irrational thought process. However, not only is intrinsic value subjective, so too are the strategies that investors use to determine that value. One investor might look only at a company’s projected growth and cash flow. Another, though, might shun these projections altogether and focus instead on the business’ present earnings and assets. Still, others use a combination of these methodologies. Even though these are all different strategies, at its core, value-based investing relies on the investor purchasing a security that is worth more than the price that is paid.

How Does the Margin of Safety Protect Value-Based Investors?

By applying a margin of safety, value-based investors can protect themselves and keep their losses to a minimum that they are comfortable with. While no one likes to lose money, there is often some leeway in that an investor can take a loss. The trick is to determine that margin of error. Here’s an example that illustrates how this concept works:

An investor has an eye on a company whose stock is currently trading at a share price of $200. The intrinsic value of the stock as determined by the investor is $175. The investor wouldn’t purchase the stock since its current trading price is above its intrinsic value. In order to determine what price to pay, the investor might apply a discount percentage to the stock’s intrinsic value — a margin of safety — of perhaps 20 percent. This means that the investor wouldn’t feel comfortable enough to purchase the stock until its price dropped to $140 or lower. The investor might not be able to add this stock to their portfolio anytime in the near future, however, the purchase can be made confidently when the stock does reach its targeted price.

Granite Investment Advisors works closely with you to determine the best investment strategy for your goals. Learn about your own Investment Risk Tolerance with our Riskalizer and help pinpoint if a value-based strategy is right for you.

Past performance is no guarantee of future results. Returns are presented net of management fees. There can be no assurance that any of the securities referred to herein were produced for or remain in portfolios managed by Granite Investment Advisors. A complete list of all Granite Investment Advisors’ recommendations within the preceding year is available upon request. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities described herein.