The concept of a "margin of safety" in investing was first introduced by value investors Benjamin Graham and David Dodd in their 1934 book Security Analysis, and was more widely popularised by Graham in his book The Intelligent Investor. In essence, it says that the soundest way to invest is to buy stocks that are selling at a substantial discount to their "intrinsic value". This way, even if market sentiment sours or the economy slows, the investor should still be protected.
Of course, this is easier said than done. Before you can judge whether a share is overvalued or undervalued, you need to work out what its actual fair value should be. In theory even a firm with a high price/earnings (p/e) ratio could have a solid margin of safety if its expected earnings justify a high valuation. However, because most people tend to be overly optimistic about future returns, most value investors emphasise the importance of buying shares that are cheap based on simple measures such as book value (net assets).
Indeed, Graham's speciality was buying companies that were selling for less than the value of their net current assets (net assets excluding all fixed assets). He referred to these stocks as "cigar-butts": they might not have good prospects, but there was enough in them for one last puff. Even if the underlying business was in permanent decline, they could be wound up and their assets sold off. So if any investor bought the stock at far less than the value of the assets, they'd still make a good profit.
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Even this isn't simple. Stocks that are theoretically trading below their book value may not be as cheap as they seem, because the assets may include "intangibles" like patents, land rights or goodwill. These are subjective and hard to value until you have to sell. What's more, stocks that are cheap by Graham's standards are rare these days.
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Nonetheless, research seems to bear out the idea that buying stocks that are cheap relative to assets is a sound strategy. For example, between 1927 and 2010, the 10% of US stocks with the lowest price/book ratios returned an average of nearly 18% per year, according to research by Aswath Damodaran of New York University. The 10% with the highest price/book ratios averaged just 11% per year.
What margin of safety should you require?
Whether one can still follow the same approach Graham did is questionable. For most of his career, he advised investors to spend a lot of time investigating firms to identify cheap stocks, but he would later conclude that easier access of information had reduced the number of bargains available. Shortly before his death in 1976, he stated that he doubted whether extensive efforts to identify undervalued stocks "will generate sufficiently superior selections to justify their cost".
Nonetheless, many investors still argue that valuing stocks in a way that tries to calculate a margin of safety is the soundest approach, because it forces you to be selective. Warren Buffett likens his investment strategy to a baseball player allowed to ignore as many pitches as he likes until he sees one that he can hit out of the park ("waiting for the fat pitch"). Seth Klarman, another notable value investor, says that investors should wait for the perfect investment to come along, rather than leaping at opportunities that offer less chance of large returns.
Hence those who rigorously apply a margin of safety should end up with highly concentrated portfolios of stocks that they strongly believe in. This chimes in with evidence that between 15 and 20 investments seems to be the best balance between diversification and concentration. For example, a 2012 study of 4,723 fund managers by Danny Yeung from the University of Technology Sydney found that each manager's top 20 choices beat the market by an annual average of over 4% each year between 1999 and 2009, while only being slightly more volatile.
