A criterion of investment vs. speculation:

Many see no benefit in distinguishing the investor from the speculator.

Graham disagrees -- he believes the margin of safety may be "the touchstone to distinguish an investment operation from a speculative one." 

The speculator believes the odds are in their favor when they take their chance and they might claim a margin of safety as a result from a propitious time, skill in analysis, adviser or system, etc. But these claims are unconvincing.


http://www.conscious-investor.com/books/intelligentinvestor.pdf

The investor's concept of a margin of safety

 The investor's concept of a margin of safety rests upon a simple and definite arithmetical reasoning from statistical data.

1. There is no guarantee that the fundamental quantitative approach will be successful in the future, but no reason for pessimism. 
2. "To have a true investment there must be present a true margin of safety." 

"It is our argument that a sufficiently low price can turn a security of mediocre quality into a sound investment opportunity--provided

• that the buyer is informed and experienced and 
• that he practices adequate diversification. 

For if the price is low enough to create a substantial margin of safety, the security thereby meets our criterion of investment.


http://www.conscious-investor.com/books/intelligentinvestor.pdf

BENJAMIN GRAHAM - THE MARGIN OF SAFETY

Benjamin Graham tells us that investment policy can be reduced to three simple words: "Margin of Safety" - the price at which a share investment can be bought with minimal downside risk.

The important point here is that the margin of safety price is not the same as the price that an investor calculates a share to be intrinsically worth.

THE INTRINSIC VALUE OF A SHARE

An investor may calculate the intrinsic value of a share by differing methods and will eventually come up with a price that he or she believes represents good buying value. Graham had his methods of calculating intrinsic value, Warren Buffett has his, other successful investors have theirs.

Graham acknowledges, however, that calculations may be wrong, or that external events may take place to affect the value of the share. These cannot be predicted. For these reasons, the investor must have a margin of safety, an inbuilt factor that allows for these possibilities.

PRIME BONDS VS GOVERNMENT BONDS

For Benjamin Graham, the benchmark for calculating the margin of safety was the interest rate payable for prime quality bonds. As Graham wrote in an era when prime bonds were much more prominent, it is more practical now to adopt, as Warren Buffett apparently does, the rate of return of government bonds as the benchmark.

Graham then uses a comparative approach. If the risk in two forms of investment is the same, then it must be better to take the investment with the higher return. Conversely, an investment with higher risk, such as shares, should, when calculating the margin of safety, have a higher return

EXAMPLE

Modifying then the example that Benjamin Graham uses in his book, we can take a share investment that is yielding 10 per cent earnings. For example, company A is earning 90 cents per share and is selling in the market at 10 dollars. If the rate of return on government bonds is 5 per cent, then the share is yielding annually an excess of 5 per cent. Over a period of ten years, the excess yield will total about 50 per cent, which, in Graham’s opinion, may be enough, if the share investment was wisely chosen in the first place. Of course, the total margin of safety will fluctuate depending upon the quality of the share investment.

Even so, something may go wrong. Graham believes however, that, with a diversified portfolio of 20 or more representative share investments, the margin of error approach will, over time, produce satisfactory results.

 ACCORDING TO BENJAMIN GRAHAM:

"[To] have a true investment, there must be a true margin of safety. And a true margin of safety is one that can be demonstrated by figures, by persuasive reasoning, and by reference to a body of actual experience".

http://www.buffettsecrets.com/margin-of-safety.htm

Warren Buffett Secrets

http://www.buffettsecrets.com/index.htm

A notable feature of value investing is its strong performance in periods of overall market decline.

Whenever the financial markets fail to fully incorporate fundamental values into securities prices, an investor's margin of safety is high.

• Stock and bond prices may anticipate continued poor business results, yet securities priced to reflect those depressed fundamentals may have little room to fall further. 
• Moreover, securities priced as if nothing could go right stand to benefit from a change in perception. If investors refocused on the strengths rather than on the difficulties, higher security prices would result. 
• When fundamentals do improve, investors could benefit both from better results and from an increased multiple applied to them.

Example:


In early 1987 the shares of Telefonos de Mexico, S.A., sold for prices as low as ten cents. The company was not doing badly, and analysts were forecasting for the shares annual earnings of fifteen cents and a book value of approximately seventy-five cents in 1988. Investors seemed to focus only on the continual dilution of the stock, stemming from quarterly 6.25 percent stock dividends and from the issuance of shares to new telephone subscribers, ostensibly to fund the required capital outlays to install their phones. The market ignored virtually every criterion of value, pricing the shares at extremely low multiples of earnings and cash flow while completely disregarding book value.

In early 1991 Telefonos's share price rose to over $3.25. The shares, out of favor several years earlier, became an institutional favorite. True, some improvement in operating results did contribute to this enormous price appreciation, but the primary explanation was an increase in the multiple investors were willing to pay. The higher multiple reflected a change in investor psychology more than any fundamental developments at the company.




Ref:  Margin of Safety by Seth Klarman

Should investors worry about the possibility that business value may decline? Absolutely.

The possibility of sustained decreases in business value is a dagger at the heart of value investing (and is not a barrel of laughs for other investment approaches either). Value investors place great faith in the principle of assessing value and then buying at a discount. If value is subject to considerable erosion, then how large a discount is sufficient?

Should investors worry about the possibility that business value may decline? Absolutely. Should they do anything about it? There are three responses that might be effective.

• First, since investors cannot predict when values will rise or fall, valuation should always be performed conservatively, giving considerable weight to worst-case liquidation value as well as to other methods. 
• Second, investors fearing deflation could demand a greater than usual discount between price and underlying value in order to make new investments or to hold current positions. This means that normally selective investors would probably let even more pitches than usual go by. 
• Finally, the prospect of asset deflation places a heightened importance on the time frame of investments and on the presence of a catalyst for the realization of underlying value. In a deflationary environment, if you cannot tell whether or when you will realize underlying value, you may not want to get involved at all. If underlying value is realized in the near-term directly for the benefit of shareholders, however, the longer-term forces that could cause value to diminish become moot.

Ref:  Margin of Safety by Seth Klarman