“Margin of Safety” as the Central Concept of Investment
This is the twentieth discussion of the ModernGraham Book Club’s reading ofÂ The Intelligent InvestorÂ by Benjamin GrahamÂ (affiliate link). Â InÂ last week’s discussion, we discussed the nineteenth chapter, in which Graham briefly discussed the relationship between shareholders and management and the importance of dividends.Â Â This week we will discuss the twentieth chapter, which is titled “‘Margin of Safety’ as the Central Concept of Investment.” Â I encourage you to purchase the book (preferably by clicking the link to Amazon, because a purchase through that link will help support the club) and join in with us as we read through a chapter each week; however, even if you don’t have the book I think you will find our discussions to be very useful in your own understanding of value investing, and you can still bring a lot to the discussion from your own experiences as an investor. Â Whether this is the first day you’ve ever been interested in investing, or you have decades of experience with the stock market, we’d love to hear your thoughts in the comments below!
Please feel free to leave a comment on this post with your own responses to the questions, along with any other thoughts you have, and return throughout the next couple of days to see what others have said. If you find something that has been said by anotherÂ commentatorÂ interesting, feel free to respond to them with another comment. Â We’ve had some great discussions throughout the book club, so keep it up!
Along with Chapter Eight, this is one of the most famous chapters of the book, primarily because those two are the ones which Warren Buffett continues to tout as Graham’s greatest contributions to the investing world.Â In general, Chapter Twenty deals with the notion that investors must utilize a margin of safety because it is not possible to know where the market will head in the near future.Â Rather, the intelligent investor knows that the market is inherently unpredictable other than the fact that over time if the investor continually purchases securities worth greater than the market seeks, then the investor will eventually earn a profit.
The ModernGraham valuation model has a couple of built-in safety margins.Â First, with regard to growth, the growth rate is estimated based on past performance and up to 3 quarters of estimated future earnings.Â The earnings base utilized also relies on a weighted-average of the earnings over the last five years.Â Once the demonstrated growth rate is calculated, the model reduces the estimate by 1/4 as a safety margin, and further limits the maximum estimate to 15%.Â The second built-in safety margin is found in the overall conclusion.Â In order to receive an “undervalued” rating, the company must be trading below 75% of its estimated intrinsic value.Â Together, these two safety margins help create a reliable model for the intelligent investor.
Please leave a comment below and feel free to answer any of these questions, or just give your general thoughts.
- What quote from this chapter do you think best summarizes the point Graham is making?
- What Safety Margins do you utilize in your investing?
- What did you think of the chapter overall?
Next Week’s Discussion:Â General Reflections
This was the last chapter of The Intelligent Investor.Â Next week we will reflect back on this edition of the ModernGraham Book Club and provide some thoughts on the club going forward.
What are some other ways to participate?
If you are a blogger, you can give your thoughts in a post on your own site, link to the discussion here on ModernGraham, and I will be sure to let our readers know that the conversation is going on over at your site as well.
In addition, you can use the hashtag #MGBookClub in social media to talk about the book on Twitter or Facebook!