The Business of Value Investing.pdf

94 The Business of Value Investing

discretionary restaurant like the Cheesecake Factory that competes

with thousands of restaurants each day. The margin of safety is like

an investor ’ s insurance policy. The wider the coverage of that pol-

icy, the more protection you have. Investing with a margin of safety

does not eliminate investment loss. Investing with a margin of safety,

however, does reduce the likelihood of losing signifi cant sums of

money in any particular investment.

Investing with a margin of safety of your choice means that

your fi rst goal when looking to invest is to focus on return of — not

on — capital. Once you ’ ve determined a fl oor price based on a fun-

damental valuation approach, then investing at or below that fl oor

price ensures that your return of capital is not at a high risk of loss.

The most common type of margin of safety occurs when a

company ’ s tangible assets far exceed its market value. Graham was

famous for seeking out net - net values, or securities selling for less

than two - thirds of current assets, less all liabilities. That ’ s the ulti-

mate margin of safety. In a situation like this, if the company were

to liquidate, the odds are very good that the equity investors would

get their capital back. But as more investors have entered the game,

these special situations have become exceedingly more diffi cult

to fi nd.

Many investors have a hard time grasping the concept of a mar-

gin of safety because it requires them to truly separate the value of

the business from the price of the stock. By way of example, suppose

XYZ Corp. was determined to have an intrinsic value of $ 50 a share

and the current stock price was $ 30 a share, implying a very com-

fortable 40 percent margin of safety. Suppose over the next month

the share price declines 33 percent and now trades at $ 20 a share.

In many cases, the declining stock price would scare investors away

although the margin of safety has just gotten wider. Suppose, however,

that the stock price declined to $ 20 and the intrinsic value declined

$ 10 to $ 40. Both have declined, but your margin of safety is still very

wide. While declining stock prices seem to imply greater risk to many

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