Benjamin Graham tells us that investment policy can be reduced to three simple words: “Margin of Safety” - the price at which a share investment can be bought with minimal downside risk.
The important point here is that the margin of safety price is not the same as the price that an investor calculates a share to be intrinsically worth.
An investor may calculate the intrinsic value of a share by differing methods and will eventually come up with a price that he or she believes represents good buying value. Graham had his methods of calculating intrinsic value, sale Warren Buffett has his, other successful investors have theirs.
Graham acknowledges, however, that calculations may be wrong, or that external events may take place to affect the value of the share. These cannot be predicted. For these reasons, the investor must have a margin of safety, an inbuilt factor that allows for these possibilities.
Prime bonds vs government bonds
For Benjamin Graham, the benchmark for calculating the margin of safety was the interest rate payable for prime quality bonds. As Graham wrote in an era when prime bonds were much more prominent, it is more practical now to adopt, as Warren Buffett apparently does, the rate of return of government bonds as the benchmark.
Graham then uses a comparative approach. If the risk in two forms of investment is the same, then it must be better to take the investment with the higher return. Conversely, an investment with higher risk, such as shares, should, when calculating the margin of safety, have a higher return.
Modifying then the example that Benjamin Graham uses in his book, we can take a share investment that is yielding 10 per cent earnings. For example, company A is earning 90 cents per share and is selling in the market at 10 dollars. If the rate of return on government bonds is 5 per cent, then the share is yielding annually an excess of 5 per cent. Over a period of ten years, the excess yield will total about 50 per cent, which, in Graham’s opinion, may be enough, if the share investment was wisely chosen in the first place. Of course, the total margin of safety will fluctuate depending upon the quality of the share investment.
Even so, something may go wrong. Graham believes however, that, with a diversified portfolio of 20 or more representative share investments, the margin of error approach will, over time, produce satisfactory results.
According to Benjamin Graham
[To] have a true investment, there must be a true margin of safety. And a true margin of safety is one that can be demonstrated by figures, by persuasive reasoning, and by reference to a body of actual experience.