Margin of safety is a key factor for any value investor. In essence, you own your securities at a low enough price to be able to better withstand adverse market conditions.
Many market participants love to chase "windmills in the sky" like Don Quixote, but usually those escapades lead to sour outcomes in the end. Paying higher and higher prices for expectations that are increasing at an increasing rate results in a cost basis that is way too high and has little wiggle room for downdrafts. Does this stop them from chasing wind mills. Unfortunately, it does not. Once burned, many will stop for awhile but will eventually go back to old habits.
To a value investor, a good defense is a great offense. The value investor has conditioned themselves to be fearful when others are excited and excited when others are fearful. When others are dour and without hope, the value investor finds "jewels" in the wreckage. He is happy to enjoy the "sale" that has arrived. On the other hand, when the market is peaking, as it currently is, he finds no joy because there are very little "sales" to be had.
What this means is when the market is reaching the top, most of the value investor's holdings are already owned at much lower prices and they are not buying unless there is a unque situation. The larger difference between cost basis and the current market value, the bigger the margin of safety. While there is no guarantee with the margin of safety, is serves to mitigate risk. Many who haven't studied history do not realize how much a security's price can climb and fall. This is why the margin of safety is so important.
For example, I own Micron Technology at 13.72. When I bought it when it was going through an earnings low point. This happens regularly in this cyclical business. The book value was about $11/share. No one wanted it! But I bought it at about 1.25 of book value. Today, the tangible book value is 15.29 which means I own it at 90% of book. That 10% is part of my margin of safety. The stock today closed at 52.03. The stock is selling at 3.8 times my cost basis. That is another factor of margin of safety. Finally, the PE of the firm today is only 8.13. The PE is much less than the market multiple. That is another facet of margin of safety. Many brokerages and stock analysis services are rating it as a buy.
While the margin of safety concept does not totally protect you from all downside risk, it mitigates that risk and puts the odds more to your favor. Compare the MU numbers I have above to a "speculator' who bought MU today at 51. Not much margin of safety there.
See what I am saying now!
