How to Invest in Stocks With a Margin of Safety

An increasing number of experts joining the economic conversation with their own predictions of a recession. James Gorman, the CEO of Morgan Stanley, said on Monday, June 13 that the U.S. economy has a 50-percent chance of entering a recession. He said that no one “can accurately predict where inflation will be a year from now.” To combat this, investors may want to look toward stocks with a margin of safety.

Here’s what investing in stocks with a margin of safety looks like, plus why experts are saying it’s the way to go in a recession-prone economy.

David Kostin, the chief U.S. equity strategist at Goldman Sachs, warned clients in a note that a recession could majorly suppress earnings estimates across the board for stocks. That means more volatility and more risk in a recession landscape, Kostin suggested.

“Some analysts have recently trimmed EPS estimates but the consensus profit outlook remains above our forecast. Prices move faster than analyst estimates,” Kostin wrote. He clarified that the stock market isn't a monolith and some stocks will perform better than others. The better-performing stocks will have an implied margin of safety, he said.

Kostin says that stocks with a margin of safety have specific features. They “trade at valuations below past bear market lows,” he wrote, adding “even after theoretical EPS haircuts.”

Analysts will look at a public company to determine a stock’s “intrinsic value,” or its true value based on financials rather than public perception. If the current stock price is lower than its reported intrinsic value, it may be underperforming and have a margin of safety.

Goldman’s Kostin listed six key margin of safety stocks for investors to pay attention to in an economy that's increasingly likely to experience a recession:

1. Best Buy (BBY)
2. T. Rowe Price (TROW)
3. Chevron (CVX)
4. EOG Resources (EOG)
5. Tyson Foods (TSN)
6. Qualcomm (QCOM)

Many of these stocks have a few things in common. For one, some have compressed valuations even amid solid performance. A lack of outpaced growth reduces the chance of valuation loss resulting from a recession.

Additionally, they offer dividends and have fairly dependable, generous yields that suggest shareholder priority.

For those that have lost value YTD, the reality of underperforming in the current market could be beneficial moving forward. Investors are going to address stock pricing at one point or another and, in certain unique circumstances, doing so early means more time for recovery.

Investors can use the margin of safety formula to value stock:

Margin of safety = 1 – (current stock price divided by intrinsic stock price)

Calculating a stock’s intrinsic value can be complex. Investors typically use one of three models to calculate intrinsic value:

1. Discounted cash flow analysis
2. PE ratio analysis
3. asset-based valuation