This principle aims to minimize risk by only purchasing securities when the market price is significantly below the estimated intrinsic value. Value investing requires a margin of safety to ensure the investor will have some protection from errors made in the estimate, market declines, or other unforeseen events. Investors may have different methods of calculating intrinsic value and the estimate is not meant to be a precise number as would be required in engineering or physics. Estimates of intrinsic value should be conservative and not be based simply on management’s projections or a rosy scenario in order to be sure that the margin of safety is reliable.

Mr. Market is an allegory that first appears in Benjamin Graham’s 1949 book, The Intelligent Investor.  Mr. Market is portrayed as a hypothetical investor who is often driven by panic or excitement. He possesses bipolar characteristics and approaches his investing as a reaction to his mood, rather than through fundamental analysis. Ben Graham created Mr. Market to demonstrate the importance of rational decision-making with regard to one’s investment selections. The important thing to remember is that these mood swings can often create opportunities but should not dictate a knowledgeable investors own behavior.

When you purchase securities, you are not just buying pieces of paper meant to be traded, but a fractional ownership of a business or its obligations. The market price does not always accurately reflect the true intrinsic value of a company or an asset. The real intrinsic value is an estimate of the present value of all the cash flows which will accrue to the owner between now and end of its useful life. Tangible factors used in the estimate may include items such as the strength of the company’s balance sheet, hard assets, annual dividends rates, or a competitive advantage such as a wide distribution network that is difficult to replicate. A company’s brand, such as Coca-Cola, acts as an intangible value which helps widen the company’s competitive moat. Microsoft and Apple have significant network effects associated with widely installed bases that are also difficult to replicate and contribute to the company’s intrinsic value.

Graham defined investing as “one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” Unlike investing, which is based on fundamentals and analysis, speculating often involves high-risk trades which more closely resembles gambling. Speculators will often try to make educated guesses and take high-risk trades in order to produce high returns. Without the proper scrutiny and analysis, this leaves the speculator open to the possibility of permanent loss of capital. The internet stock bubble of the early 2000’s is an excellent example of the downside of speculating.

This expression is a short metaphor to describe the concept of getting more than what you pay for when you purchase a stock, bond, or any asset. The market price does not always accurately display the true value of the asset. Although the market is mostly efficient, there is little question that pockets of undervaluation will often (but not commonly) exist.

Value investing often involves investing in companies that have fallen out of favor with the public, that are ignored, or that may be suffering from a poor business cycle or recession. Investing in these companies is often contrary to conventional thinking, which requires discipline and the ability to tune out noise from most media channels. As Mr. Buffett likes to say:  “You are neither right nor wrong because the market agrees with you in the short term. You’ll be right if you have your facts and your reasoning correct.”

Graham wrote, “In the short run, the market is a voting machine but in the long run it is a weighing machine.” Eventually the market revalues these companies when the economy or the industry’s prospects improve. This does not always happen overnight and it often can take three to five years.  Having the discipline to hold securities for the long term and possessing an adequate margin of safety can create a significant edge over many institutional investors who are focused on the next quarter’s earnings or a stock’s current “momentum”.