Issue #30: How Smart Investors Protect Their Portfolio
The one investing rule Warren Buffett swears by.
Reading time: 7 minutes
When I first started investing, my strategy was... well, let’s just say it was simple:
If I had the money, I’d put it into a stock I liked, no matter the price. I figured,
"Hey, it’s a good company, and good companies are going up, right?"
And sometimes, I was right. But most of the time, I was very, very wrong.
Eventually, I hit stage two of my investing journey:
"OK, I need to actually research the business before I invest."
I started reading about the companies I was buying, checking what they did, who their customers were, and whether I believed in their products.
Then came stage three:
"Wait... I should also be looking at the numbers."
Does the company even make money? Is its debt going up or down? Has the company's revenue consistently grown, and have its margins improved over time?
But the most important realization came after all that.
It was the concept I wish someone had told me on day one: Margin of Safety
Margin of Safety
The margin of safety means buying an investment for less than what you think it’s really worth. This gap between value and price is your safety cushion.
For example, if a stock’s true value (its intrinsic value) is estimated at $100, but you can buy it for $70, you have a $30 margin of safety. By paying much less than it's worth, you give yourself room for error in case your analysis was too optimistic or if the market turns against you.
A good margin of safety can help protect you from volatile price swings by ensuring you buy in at a bargain price rather than at the peak of hype.
The term Margin of Safety in investing was popularized by Benjamin Graham (known as the “father of value investing”).
Graham suggested always leaving room for the unexpected. And one of Graham’s students, the man, the myth, the legend Warren Buffett, calls the margin of safety principle “the cornerstone of investment success.”
He often emphasizes never losing money, and one way to do that is by never overpaying. In fact, Buffett has been known to wait until he can buy at half of what he thinks a business is worth (a 50% discount). That large gap gives him confidence that even if things go wrong, he’s unlikely to lose big.
One way to understand the margin of safety is to think like an engineer.
When engineers build a bridge expected to carry 10,000 kilo trucks, they don’t design it to hold just 10,001 kilo, they might build it to hold 30,000 kilos just to be safe. The extra strength is a margin of safety in construction.
Similarly, in investing, you don’t want to drive a heavy truck over a weak bridge. If you think a stock is worth $83 per share, you wouldn’t want to pay $80; that’s too tight. Instead, you might wait until it’s, say, $50 or $60, giving yourself a much bigger cushion.
Why do you need this cushion?
Because investing is full of uncertainty, especially if you’ve chosen the harder path of picking individual stocks instead of just buying the S&P 500 or Bitcoin and forgetting about it.
The future is hard to predict. Companies can have bad earnings, economies can downturn, or unexpected news can crash a stock. The margin of safety acts as a buffer against mistakes or bad luck. If you were a bit too optimistic in valuing the company, or if an unforeseen problem hits, a margin of safety means you still might not lose money because you bought in at a low price.
How to Use Margin of Safety When Picking Stocks
First, we need to figure out the stock’s intrinsic value, essentially, what the company is really worth based on its business. There are a few ways we can estimate intrinsic value:
Discounted Cash Flow (DCF): This method projects a company’s future cash flows (how much money it will generate) and then “discounts” them back to today’s value. DCF is a bit math-heavy, so if you’d rather not calculate it yourself, you can use a combination of these three free websites instead.
2. GuruFocus
3. Finbox
Earnings Power Valuation (EPV): This approach looks at the company’s current earnings and assumes no growth, asking “if this company kept earning what it does now every year, what is that worth?” You can use the same three free websites mentioned above to get a quick estimate for this too.
You have to aim for stocks that are anywhere from 20% to 50% below their intrinsic value before buying. The more uncertain you are about the business, the bigger margin of safety you might want. For a stable, predictable company, you might be comfortable with a 20% margin. For a riskier business (say, a tech startup that’s harder to predict), you might demand a 50% margin of safety to feel secure.
Real-World Example: Is PayPal a Good Buy?
Let’s look at a real-world example. As you know, I like to keep things simple because, honestly, the simpler you keep it, the better.
Sure, doing the math yourself is ideal. But not everyone wants to crunch numbers. What everyone wants is to find that one opportunity that could change their life, or at least improve it, with minimal effort.
And I’m not joking, that’s actually possible.
If you’re willing to invest the same amount of time it takes to watch 3 or 4 episodes of your favorite show, you can understand a business better than 80% of investors and even some analysts.
So, let’s do exactly that and walk through a basic margin of safety analysis of a company we all know: PayPal (PYPL 0.00%↑).
It’s a household name. A payment company with strong brand value. But since 2021, its stock has been absolutely butchered. The stock has dropped from $309.14 to $64.
Now, the big question: Is it a good buy today?
Finbox: ~$89.675
GuruFocus: ~$97.82
ValueInvesting.io: ~$107.42
Average: $98.31
To be conservative, let’s round down and say PayPal’s fair value is around $80. At the end of the day, it wasn’t you crunching the numbers; these are estimates from external models, and they could be off. So let’s apply an extra layer of caution and drop about 20% from that value just to be safe.
That gives us an adjusted fair value of around $80. If you’re buying at $64, you’re stepping in with a solid 20% margin of safety.
So yes, based on this analysis, PayPal looks like a buy. Of course, you should also check the company’s financials, fundamentals, and recent performance, but (P.S. I did, and everything is good).
Extra Tips
Once you determine a target “buy price” that gives you a comfortable margin of safety, you might have to be patient. The stock could trade above your target for a long time.
It’s okay to wait on the sidelines until a stock falls into your buy zone. This requires discipline. It’s not easy watching a stock and refusing to buy until it hits your price. And after buying, you might wait months, even years, for the market to recognize the value you saw.
If you demand a margin of safety, you’re implicitly saying, “I’m okay sitting and waiting because I’d rather not risk my money on a pricey investment.”
Another point is to remember that intrinsic value is an estimate and not a certainty. Two different analysts can come up with very different values for the same stock. Always be conservative in your assumptions. It can help to double-check your own and others’ work or even use multiple methods.
Even then, acknowledge that you could be wrong. The margin of safety is there to cushion errors, but if your error is huge, the cushion might not save you. Just don’t let the concept lure you into a false sense of security; do your homework thoroughly.
Lastly, please do not forget the “safety” part. Sometimes you do all the analysis, identify the intrinsic value, but then get greedy and buy a stock just 5% or 10% below your intrinsic value estimate, thinking, “it’s close enough.”
That’s not really following the margin of safety principle. If you cut the cushion too thin, you’re not really protected if your analysis is slightly off or if the market turns against you.
It’s like thinking you can drive that 10,000-kilo truck over a bridge that holds 10,001 kilos; you’re technically under the limit, but there’s essentially zero room for error.
Don’t rationalize paying a price that doesn’t offer a solid buffer. If you can’t get a big enough discount, it’s okay to pass and wait. The market offers fresh opportunities every week, month, and year. Discipline means sometimes doing nothing until the right stock comes.
Thank you so much for reading! See you next week.