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Protect Yourself With A Margin Of Safety

By Louis H-P on May 19, 2020

Reading Time: 3 minutes

Speak to an older person about taking a risk and they will mention giving yourself a margin of safety. Older generations have seen downside risk before, so develop a wise approach to upside risk. They know that without an opportunity you cannot develop, but also know new opportunities mean risks. Taking a risk is itself not a bad idea, but mitigating that risk with some form of portfolio protection, will probably be the difference between moving forward or being stopped in your tracks.

Key Takeaways

Understand margin of safety

How to apply it

How to profit from being cautious


What is margin of safety?

A margin of safety is giving yourself some room to manoeuvre if it all goes wrong. Whether we like it or not, systematic risk will always exist. If you have committed your entire capital in a risky investment or momentum trading, you are in no position to survive a crisis and worst, take advantage of it. An example would be property, which for many is their first investment.

Taking out a mortgage which absorbs the majority of your excess cash after bills, leaves no margin of safety if you lose your job. If you take out a mortgage which only requires 30% of your salary, you are able to save a portion of the rest, ensuring you have money for a rainy day.

Protection from volatility

Market timing is very hard. I would not recommend basing your investment strategy on it. Yet ignore it altogether at your peril. Volatility comes part in parcel with markets. The most volatile stocks are unlikely to generate consistent long-term share price appreciation for you.

Buying hot stocks which drop -20% one minute, only to bounce back up +15% on a positive trading update is no use to you. You will still be -5% at the end of it. If you looked at the financial accounts, in particular said company’s free cash flow generation, then you can work out its intrinsic value.

Use volatility to your advantage.

If during a sell off the value of the company falls below this intrinsic value, then you can buy the dip with confidence that you are investing at (the right time) at a discount. Once the market rights itself and realises it has mispriced said company, you will be in profit. You will also still be in profit if the shares fall further, due to your margin of safety, to exit out at a reduced loss or even a (very small!) profit.

Quality not quantity

There was no margin of safety in WeWork's valuation

One of the best forms of margin of safety, is investing in a company with a strong competitive advantage, sound financials and who is able to evolve and meet new challenges. Companies which over promise and fail to deliver can cost investors everything. Think about investors in WeWork whose investment have lost huge value, because the company is not generating any free cash flow whilst promising to change the world. Once the marketing bubble was pricked, there was nothing to sustain its valuation.

There was simply no margin of safety.

Contrast that with Next plc which is in the worst competitive landscape ever because of the rise of online shopping and destruction of the high street. Yet any investors who has followed Next will know about their conservative approach to accounting and their ability to evolve. This should ensure they will not only survive this crisis, but are likely to prosper once through it. (editor’s note: there will be pain for them in their immediate future!)

Conclusion

Equity Risk is such, you should always consider giving yourself a margin of safety when investing in a stock portfolio. This may include overvalued stocks whose premium to others leave little room for disappointment. A profit warning can leave you nursing a -20% (unrealised) loss in minutes.

The first step you can take to ensuring a margin of safety, is investing in companies with solid financials. This will include, no debt, strong cash flow and a high margin. Few companies display these traits in today’s debt laden world. This in itself may be the signal to not invest. Remember if there is no margin of safety, everything has to go perfectly right… and how often has that happened?!

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Louis H-P

Louis is a portfolio manager and a trader who brings a wealth of experience in private banking to The Lazy Trader. A fundamentalist and a trouble-shooter, Louis makes a firm contribution to the trading team.

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Louis H-P

Louis is a portfolio manager and a trader who brings a wealth of experience in private banking to The Lazy Trader. A fundamentalist and a trouble-shooter, Louis makes a firm contribution to the trading team.

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