What is the margin of safety?
The margin of safety is the difference between the fair value of a stock and its market price.
Warren Buffet says, ‘price is what you pay, and value is what you get.’
The margin of safety is the difference between the fair value of a stock and its market price. If you are paying a price that is less than the fair value of the company, then you can cover any missouts. This miss-out could be related to prospects of the company, industry prospects, or any other variable which probably you did not consider.
What should be the margin of safety? There is no right or wrong answer, it depends upon the business you are trying to understand. If you are looking at not a high-quality business, you ought to have a high margin of safety say 50%. And in case you’re looking at a high-quality business that produces cash flow regularly and there is a long history to validate it, the margin of safety can be less.
So, what can go wrong?
An adverse change in the competitive landscape
The competitive landscape tends to be structural however the occasional change in the competitive landscape can significantly affect a company’s future. For example, Airtel's leadership position in telecom was challenged by Reliance Jio.
Digital disruption virtually impacts all kinds of businesses. For example, brokerage firms such as ICICI Direct, Hdfc securities, and Kotak securities were challenged by Zerodha which gained almost 10% of the market share. This was possible only due to a better and user-friendly tech-based trading solution.
Adverse change and regulatory framework
Regulations can have a serious impact on sectors and companies. So, any price control imposed by the government on pharma companies or agriculture, etc. can ruin these companies overnight.
There can be capital misallocation by the management. It is a major risk for the minority shareholders since they don’t have any control over the working of the company. Management can use the excess cash flow towards making a big acquisition or putting a new plant without understanding the implication of that plant.