As you go through life, you are always looking for a margin of safety as a cushion against risk and the unexpected. It’s what keeps you out of trouble or protects you from danger. A margin of safety in investing is no different, but it is the key to building wealth.
Many of us, once we’re well into adulthood, tend to view life through the lens of a “margin of safety.” That is, we seek where we can create a risk cushion around our daily activities to avoid danger or negative outcomes. For example, we might avoid turning into a parking spot narrowed by cars on both sides that have parked too close to the lines. Rather than risk a ding, we look for a greater margin of safety by parking further away if it meant not having to worry about it.
When applied to investing, it’s that same margin of safety that creates a risk cushion around stocks, providing protection during periods of market turbulence. As in life, when investing in stocks, something is almost certain to go wrong, typically as a result of circumstances beyond your control. But, if you can buy a stock for less than its intrinsic value, you would have less downside risk and greater upside potential. At that particular moment, the stock has a margin of safety. However, if you wait to buy the stock until after its price goes up and becomes more fairly valued – or overvalued – it no longer has a margin of safety.
Whether in life or investing, we need a margin of safety to account for the unexpected.
I recently had an experience that really brought this concept home. I fly out of Pittsburgh, which means I almost always have to go through somewhere else to get to my ultimate destination. On my last trip, I flew to Charlotte for a connecting flight. After deplaning in the C terminal, I saw on the board that my next flight was departing from the D terminal in about 40 minutes. I had my luggage with me and I knew from previous experience that 40 minutes was plenty of time to make the connection – it was a more than sufficient margin of safety.
But, as I arrived at the gate in terminal D, I was informed that there had been a gate change. The flight was now departing from the B terminal – two terminals away! The clock was ticking. Fortunately, there was a shuttle leaving right from that gate that would take me to the B terminal. Just as I arrived, they were announcing the last call for boarding my plane. I made my flight, but with no time to spare.
This is not an uncommon scenario for anyone who travels a lot. When making connections, you can schedule yourself for very little time or for a lot of time. In this circumstance, time is your margin of safety. In this case, I scheduled a sufficient margin of safety in anticipation of the unexpected. You don’t need a margin of safety as an allowance for what is expected; you need a margin of safety for the unexpected – for those gate changes in life or investing.
Why We Look for a Margin of Safety in Stocks
When investing in stocks, price becomes your margin of safety. If you invest in a company that’s worth $10 billion and the stock valuation is $10 billion, you get a fair value for your money. That’s okay if your assessment of that company’s worth is based on sound assumptions and that nothing will change. Though in reality, there are a thousand things that could have a direct and negative impact on industries, economies or even individual companies. You could have everything lined up – the gate, the flight, and the time – but if there’s a gate change, you may have an insufficient margin of safety.
For a deeper dive into this, consider Gentex (NASDAQ: GNTX). By all measures, Gentex is a phenomenal company – with an incredible 92% global market share of auto-dimming rearview mirrors for cars and trucks. That means, if you drive a vehicle with an auto-dimming rearview mirror, it’s probably a Gentex product.
Warren Buffett once said, “I want to buy castles with moats around them.” With 92% market share and thousands of patents around the technology that goes into their product, Gentex has a serious moat around them. While that moat protects the company from any serious competition, it does not, in and of itself, protect the company from external events.
Making the Margin of Safety Work
When we invested in Gentex, it had a more than adequate margin of safety. The problem is, Gentex gets most of its revenue from Toyota and some other global auto manufacturers. However, in anticipation of potential gate changes, we waited to buy Gentex at about 25% below its intrinsic value for a significant margin of safety. Sure enough, the company experienced two significant gate changes within the first year of our investment.
First, was the tariff war with China, which was a direct hit on the auto industries and Gentex in particular. Our assessment of the value of Gentex was based on the sales and earning rates of the company and the tariffs slowed those rates. The second gate change occurred just months later when General Motors auto workers decided to go on strike, creating an additional drag on sales.
Gentex stock was hit hard, marking down the value of the company at least in the short run. But that was okay because we had a margin of safety of 25% of the value of the company in the short run, falling nearly 25%. We had a margin of safety of 25% of the value the company, which means we didn’t overpay. Its share price has since recovered, recently hitting a new high.
Based on our thorough research and analysis, we know that Gentex is a great company. But great companies aren’t always great investments. However, due to our insistence on waiting to buy it until it had a significant margin of safety, it’s looking like it will be a great investment.
