That is what it feels like when you have a margin of safety.

What exactly is a margin of safety?

The term was coined by the famous father of value investing, Benjamin Graham. In his book, the Intelligent Investor, he says:

We have here, by definition, a favorable difference between price on the one hand and appraised value on the other. That difference is the safety margin. It is available for absorbing the effect of miscalculations or worse than average luck.

Benjamin Graham’s most famous “student” is none other than Warren Buffet, the greatest investor of all-time.

This concept pervades everything Warren Buffet does. Buffet doesn’t worry about the day-to-day fluctuations of his investments. His portfolio swings up in down each day in the BILLIONS of dollars. And I’m pretty sure he sleeps like a baby.

When he invests in a business, he does two essential things:

1. He looks at all of the aspects of a business and arrived at what he believes the intrinsic value is. Typically these are well-known, well-run, highly profitable companies with strong balance sheets and a competitive edge.
2. He makes sure he buys the company/stock at a price that is well below the mark where he determined the intrinsic value to be.

I’m quite sure that Warren Buffet has a huge list of companies that he would absolutely love to invest in, but he doesn’t own a single share of any of them. That is because he believes that the current price that he would pay is not providing him the margin of safety….it is either overvalued or fairly valued.

So he waits.

He waits for a situation where the price has declined to a ridiculous value below what he knows the true worth of a company to be…and then he pounces. He makes his money by buying a company at a very fair price.

I’m not a value investor. But the concept is one which any investor should utilize. One of the few things that you can control as an investor is the price you have paid.

My interpretation of the Margin of Safety

Benjamin Graham does mention growth stocks (the opposite of value investing) in the Intelligent Investor. With growth stock investing, companies that you are buying are selling at a very high price compared to their current earnings (a high P/E ratio). That is because investors in these stocks are really buying the future earnings…the company is expected to be huge in the future and they are willing to pay a premium now to get in.

And it is in the future that Benjamin Graham (and Warren Buffet) would say the danger lies. It is extremely difficult to know that the current torrid pace of a company’s sales growth or earnings growth will continue in the future.

The growth-stock approach may supply as dependable a margin of safety as is found in the ordinary investment – provided it shows a satisfactory margin in relation to the price paid. The danger in a growth-stock program lies precisely here.

Benjamin Graham – The Intelligent Investor

It pains Ben Graham and Warren Buffet to buy a stock that they feel is to pricey today, one that relies on the rapid pace of earnings and sales growth to continue at the same or faster pace into the future. One single slip-up and a growth stock can plummet like a rock.

I think in some ways, they are missing out though. Warren Buffet didn’t buy Apple when he should have. Though he has done well owning Apple today and it comprises a huge portion of his investment portfolio…he probably should have bought Apple many years before.

For example, would he have have bought Shopify (SHOP) back in 2016 or 2017?

I would say no say he would have touched it with a 10 foot pole. The company had an astronomical P/E ratio and was “expensive” back then.

Here is a weekly chart of Shopify back then:

This is a poster-child for a typical growth stock. Even back then in 2016 to 2018, you are paying a hefty price for the earnings. The stock is expensive, for sure.

But the thing is…it can get more expensive.

Here is a weekly chart of Shopify (SHOP) up until the present day (2021)

Yep, now it is at $1,435.

I don’t think that investing in Shopify investing was a risky investment back then. Why? It certainly didn’t have the traditional “margin of safety” that Ben Graham and Warren Buffet would look for.

But in my opinion it had and still has a margin of safety. Where?

In it’s business model.

Shopify has a moat around it that is so huge, so significant, that it has almost no competitors. Sure, it has competitors:

1. WooCommerce
2. Magento
3. OpenCart
4. BigCommerce

But Shopify has essentially eaten the lunch from all of these other players.

• Their technology is better.
• Their integrations with Amazon is better (one might say that Shopify is the Amazon of eCommerce).
• Their customers are “sticky” and loyal.

The company has a margin of safety.

The margin of safety is not in the traditional sense, but in it’s competitive advantage. In hindsight, looking back at what Shopify has done, it is obvious that nobody was overpaying for that company back in 2016-2018. One could see that it had a clear an unobstructed path to absolutely dominate their niche in eCommerce. There was a lot of room for error.

There surely would be a quarterly earnings report that disappointed the market. But that is a blip. Focusing on something like a quarterly earnings report is meaningless when one steps back and looks at the bigger picture.

That is what I look for in my system

When I initially set about to grow my non-retirement savings from absolutely nothing, I used the concept of margin of safety.

With my method, I am not entirely focused on the traditional concept of margin of safety. I think it is also important to take a look at the bigger picture. Sure, the stock might be “richly” valued today, but if they have a dominant position, or a unique story with catalysts that are very likely to bear fruit in the future… I’m going all in.

I felt the same way about APPS before it blew up. I feel the same way about GNSS, OIIM and SMSI today.

When you have a unique story, one where there are numerous catalysts that appear obvious when you step back and look at the big picture, what looks pricey today is actually pretty cheap.

If there is a very reasonable likelihood that those catalysts are going to take place, the risk isn’t so high. There is a high margin of safety there.

What are your thoughts?

Glenn