{"id":5428,"date":"2015-04-07T09:26:16","date_gmt":"2015-04-07T13:26:16","guid":{"rendered":"http:\/\/www.jasonapollovoss.local\/?p=5428"},"modified":"2018-09-21T02:03:45","modified_gmt":"2018-09-21T06:03:45","slug":"margin-of-safety-the-lost-art","status":"publish","type":"post","link":"https:\/\/jasonapollovoss.com\/web\/2015\/04\/07\/margin-of-safety-the-lost-art\/","title":{"rendered":"Margin of Safety: The Lost Art"},"content":{"rendered":"<p><span style=\"font-size: 16px;\">In another era, Benjamin Graham, one of history\u2019s greatest investors, opined in <a title=\"The Intelligent Investor\" href=\"http:\/\/www.amazon.com\/Intelligent-Investor-Book-Practical-Counsel\/dp\/0060155477\/ref=sr_1_3?ie=UTF8&amp;qid=1427728926&amp;sr=8-3&amp;keywords=the+intelligent+investor\"><em>The Intelligent Investor<\/em><\/a> about the importance of including a margin of safety in assessing the quality of any investment: &#8220;to distill the secret of sound investment into three words, we venture the motto, <a title=\"Margin of Safety | Investopedia\" href=\"http:\/\/www.investopedia.com\/terms\/m\/marginofsafety.asp\">MARGIN OF SAFETY<\/a>.\u201d Graham\u2019s many adherents, including the fabulously successful Warren Buffett, Bruce Berkowitz, and Seth Klarman (who even wrote a book entitled\u00a0<em><a title=\"Margin of Safety: Risk-Averse Value Strategies for the Thoughtful Investor\" href=\"http:\/\/www.amazon.com\/Margin-Safety-Risk-Averse-Strategies-Thoughtful\/dp\/0887305105\/ref=sr_1_1?s=books&amp;ie=UTF8&amp;qid=1427913993&amp;sr=1-1\">Margin of Safety<\/a><\/em>), all also emphasize the importance of the concept of margin of safety.<\/span><\/p>\n<p><span style=\"font-size: 16px;\">Klarman says: \u201cThere are only a few things investors can do to counteract risk: diversify adequately, hedge when appropriate, and invest with a margin of safety. It is precisely because we do not and cannot know all the risks of an investment that we strive to invest at a discount. The bargain element helps to provide a cushion for when things go wrong.\u201d<\/span><\/p>\n<p><span style=\"font-size: 16px;\">Each of these supreme investors agree about the power of recognizing that the future rarely, if ever, unfolds how you modeled it to unfold.<\/span><\/p>\n<p><span style=\"font-size: 16px;\">So what is the lost art of the margin of safety? In short, the margin of safety is a \u201cfudge factor,\u201d a specific amount of extra conservatism built into your estimate of value for a security, because:<\/span><\/p>\n<ul style=\"margin-left: 5%;\">\n<li style=\"padding-bottom: 3%;\"><span style=\"font-size: 16px;\">The future is unknowable.<\/span><\/li>\n<li style=\"padding-bottom: 3%;\"><span style=\"font-size: 16px;\">Preservation of capital, not return on capital, is Job One\u00a0of investors.<\/span><\/li>\n<li style=\"padding-bottom: 3%;\"><span style=\"font-size: 16px;\">Your model is inevitably wrong.<\/span><\/li>\n<\/ul>\n<p><span style=\"font-size: 16px;\"><strong><em>Margin of Safety for Equity<\/em><\/strong><\/span><\/p>\n<p><span style=\"font-size: 16px;\">Qualitative definitions of the margin of safety are mostly in agreement with one another and adhere closely to the definition given above. Yet, interestingly, there is no agreed upon quantitative definition of the margin of safety. This is what makes this concept an art!<\/span><\/p>\n<p><span style=\"font-size: 16px;\">To inspire your imagination, here are some possible quantitative ways of calculating the margin of safety:<\/span><\/p>\n<p><span style=\"font-size: 16px;\"><strong>If (Fair Value \u00f7 Market Price) \u2013 1\u00a0\u2265 Margin of Safety \u2192 Buy<\/strong><\/span><\/p>\n<p><span style=\"font-size: 16px;\">Here a research analyst estimates the fair value of the equity of a business and compares this estimate to the market price. In order to purchase shares, the fair value must exceed the market price by at least the analyst\u2019s preferred margin of safety. Here the margin of safety is arbitrary.<\/span><\/p>\n<p><span style=\"font-size: 16px;\">In my career, I usually used a margin of safety of 15%. Why? Because I figured that my fair value estimate was likely off by \u00b115%, on average (i.e., a 30% range). For Google (<a title=\"GOOG | Yahoo! Finance\" href=\"http:\/\/finance.yahoo.com\/q?s=GOOG\">GOOG<\/a>), this means your fair value estimate must be $635.31 if its stock price is $552.44.<\/span><\/p>\n<p><span style=\"font-size: 16px;\"><strong>If (Fair Value \u00f7 Market Price) \u2013 1\u00a0\u2265 Coefficient of Variation \u2192 Buy<\/strong><\/span><\/p>\n<p><span style=\"font-size: 16px;\">My use of 15% above is entirely arbitrary. Clearly for some businesses where it is difficult to estimate their fair value, a 15% level may not make much sense. Likewise, shares in a utility, where cash flows and costs of capital are easier to estimate, you might use a lower margin of safety. If you believe this is the case, then you will like this measure better.<\/span><\/p>\n<p><span style=\"font-size: 16px;\">Here you want your margin of safety to be at least the coefficient of variation. The coefficient of variation is calculated as: 1-year standard deviation \u00f7 1-year average stock price. Take Apple (<a title=\"AAPL | Yahoo! Finance\" href=\"http:\/\/finance.yahoo.com\/q;_ylt=AqKgSbbvRcRwYNyI5NJSPlGp_8MF?uhb=uhb2&amp;fr=uh3_finance_vert_gs&amp;type=2button&amp;s=aapl\">AAPL<\/a>), for example, its standard deviation over the last year is 14.9, and its average stock price (split-adjusted) is $102.02, making for a coefficient of variation of 14.6%. An analyst using this method would want her estimate of fair value to be $116.91.<\/span><\/p>\n<p><span style=\"font-size: 16px;\"><strong><em>Margin of Safety for Fixed Income<\/em><\/strong><\/span><\/p>\n<p><span style=\"font-size: 16px;\">Fixed-income securities are a contractual obligation between a borrower and a lender. This contractual nature tends to shift the analysis for fixed-income analysts away from the valuation of individual securities, and instead onto an evaluation of the credit worthiness of the issuer. Analysis at that level is definitely one version of a margin of safety. However, many analysts simply take the overall credit rating of the issuer, or its issue, from a credit ratings agency at face value to determine the appropriate credit spread to value a security.<\/span><\/p>\n<p><span style=\"font-size: 16px;\">Here are some possible alternative versions of a margin of safety:<\/span><\/p>\n<p><span style=\"font-size: 16px;\"><strong>Collateral<\/strong><\/span><\/p>\n<p><span style=\"font-size: 16px;\">Proof that the margin of safety is a lost art, even in the realm of fixed income, is the overwhelming number of \u201cunsecured\u201d issues in comparison to \u201csecured\u201d issues. Secured means the fixed-income security is backed by collateral \u2014\u00a0alias, a margin of safety. Thus, if you want greater margin of safety, buy more issues backed by collateral. In a mortgage-backed security, you would want high levels of equity backing the mortgages.<\/span><\/p>\n<p><span style=\"font-size: 16px;\"><strong>Use the Credit Spread of One Credit Level Lower<\/strong><\/span><\/p>\n<p><span style=\"font-size: 16px;\">Fixed-income investors could also use a more conservative credit spread in their calculation of fair value for an instrument than that implied by an issue\u2019s <a title=\"Overview of Alternatives to Credit Ratings\" href=\"http:\/\/blogs.cfainstitute.org\/investor\/2012\/03\/14\/an-overview-of-alternatives-to-credit-ratings-2\/\">credit rating<\/a>. So if an issuer has an A- credit rating, then analysts could use the credit spread for BBB+ issuers for a similar maturity length security in assessing fair value.<\/span><\/p>\n<p><span style=\"font-size: 16px;\"><strong>Add a Premium to the Credit Spread<\/strong><\/span><\/p>\n<p><span style=\"font-size: 16px;\">Another alternative is simply to add an arbitrary percentage amount to an issuer\u2019s credit spread. If the spread is 150 basis points (bps), an analyst could add 15%, or about 173 bps, to use when assessing the fair value of the instrument.<\/span><\/p>\n<p><span style=\"font-size: 16px;\">As an example, the fair value price of a \u20ac1,000 par, 3.5%, 2-year note \u2014 with a comparable euronote bearing an interest rate of 2.5%, and a credit spread for this type of issuer being 1.5% \u2014 would be \u20ac990.48. But, what if instead, the analyst builds conservativism into the spread, and makes it 15% higher, or 2.5% + [1.5% x (1 + 15%)] = 4.225%? Here the fair value estimate falls to \u20ac986.23.<\/span><\/p>\n<p><span style=\"font-size: 16px;\"><strong><em>Margin of Safety for Derivatives<\/em><\/strong><\/span><\/p>\n<p><span style=\"font-size: 16px;\">Derivatives are the modern superstars of finance with many risk factors and sensitivities to these risk factors an explicit part of the daily discussion of such securities. So you would think derivatives must have a built in margin of safety. But I would argue that nowhere is margin of safety more of a lost art than in derivatives pricing!<\/span><\/p>\n<p><span style=\"font-size: 16px;\">Most derivatives investors do not have an independent assessment of the valuation of the underlying security. Instead, they take the market price of the underlying at face value because they simply want to calculate the price of the derivative itself. Likewise, the value of the derivative comes from a modeled price; consequently, the price of the derivative is taken at face value, too.<\/span><\/p>\n<p><span style=\"font-size: 16px;\">Risk management is handled after the fact by hedging. As the market fluctuates, derivatives investors simply adjust their hedge. But this assumption relies upon a liquid and stable market for these assets. If the market suddenly moves\u00a0\u2014 exactly the moment when you want a margin of safety \u2014 it can be very difficult to adjust the hedge. In other words, there is no margin of safety built in to the valuation of derivatives.<\/span><\/p>\n<p><span style=\"font-size: 16px;\">Here are some suggestions for margin of safety for derivatives:<\/span><\/p>\n<p><span style=\"font-size: 16px;\"><strong>Have a Fair Value Estimate of the Underlying Security<\/strong><\/span><\/p>\n<p><span style=\"font-size: 16px;\">I am guessing that to most of those involved in options trading this seems like a ridiculous consideration. But is it? If you get the options price correct, but the underlying security is massively overvalued and you are long calls, then you have some trouble on your hands, right? If you do not create an estimate of fair value, is there a source that you trust for such things?<\/span><\/p>\n<p><span style=\"font-size: 16px;\"><strong>Use Lower Volatility Assumptions<\/strong><\/span><\/p>\n<p><span style=\"font-size: 16px;\">Option prices are directly tied to the volatility assumptions embedded in them. As a bit of conservativism, why not use a lower volatility assumption? Discount it in a similar fashion to those methods suggested above for other instruments.<\/span><\/p>\n<p><span style=\"font-size: 16px;\"><strong>Use More Conservative Assumptions for \u201c<a title=\"Greeks | Investopedia\" href=\"http:\/\/www.investopedia.com\/terms\/g\/greeks.asp\">The Greeks<\/a>\u201d<\/strong><\/span><\/p>\n<p><span style=\"font-size: 16px;\">Different Greeks have different effects on different options. But if you are interested in preserving more of your capital and accounting more for an uncertain future, why not use more conservative assumptions for your Greeks?<\/span><\/p>\n<p><span style=\"font-size: 16px;\">In conclusion, margin of safety lies at the heart of the success of many great investors. Yet, it is a lost art. And not just in equity investing, Across the financial landscape, margin of safety is ignored . . . at your peril!<\/span><\/p>\n<p style=\"font-size: smaller;\"><span style=\"font-size: 16px;\">Photo credit: \u00a9iStockphoto.com\/HerminUtomo<\/span><\/p>\n<p>&nbsp;<\/p>\n<p><span style=\"font-size: 16px;\"><em>Originally published on CFA Institute\u2019s \u00a0<a href=\"https:\/\/blogs.cfainstitute.org\/investor\/\">Enterprising Investor<\/a>.<\/em><\/span><\/p>\n","protected":false},"excerpt":{"rendered":"<p>In another era, Benjamin Graham, one of history\u2019s greatest investors, opined in The Intelligent Investor about the importance of including a margin of safety in assessing the quality of any investment: &#8220;to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.\u201d Graham\u2019s many adherents, including the fabulously successful [&hellip;]<\/p>\n","protected":false},"author":2,"featured_media":5429,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_et_pb_use_builder":"","_et_pb_old_content":"","_et_gb_content_width":"","footnotes":""},"categories":[12,3],"tags":[254,251,252,253],"class_list":["post-5428","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-best-of-the-blog","category-the-blog","tag-benjamin-graham","tag-margin-of-safety","tag-seth-klarman","tag-warren-buffett"],"_links":{"self":[{"href":"https:\/\/jasonapollovoss.com\/web\/wp-json\/wp\/v2\/posts\/5428","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/jasonapollovoss.com\/web\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/jasonapollovoss.com\/web\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/jasonapollovoss.com\/web\/wp-json\/wp\/v2\/users\/2"}],"replies":[{"embeddable":true,"href":"https:\/\/jasonapollovoss.com\/web\/wp-json\/wp\/v2\/comments?post=5428"}],"version-history":[{"count":0,"href":"https:\/\/jasonapollovoss.com\/web\/wp-json\/wp\/v2\/posts\/5428\/revisions"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/jasonapollovoss.com\/web\/wp-json\/wp\/v2\/media\/5429"}],"wp:attachment":[{"href":"https:\/\/jasonapollovoss.com\/web\/wp-json\/wp\/v2\/media?parent=5428"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/jasonapollovoss.com\/web\/wp-json\/wp\/v2\/categories?post=5428"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/jasonapollovoss.com\/web\/wp-json\/wp\/v2\/tags?post=5428"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}