Fool's School

In his classic book "Margin of Safety," author Seth Klarman defines value investing as "the discipline of buying securities at a significant discount to their underlying value and holding them until more of their value is realized."

It's all about finding bargains. Value investors are on the hunt for a dollar selling for 50 cents. So they become very attentive during times of uncertainty — especially after big drops in stock prices. Still, they mustn't overlook the need for a margin of safety.

It's easy to think that when a stock price gets very low, it surely can't go any lower. Thinking about a stock in this manner is misguided and can lead to financial pain. After all, until a stock price has reached zero, it can always go lower.

Understand that a stock's current price in the market and its intrinsic value are two different numbers. You'll rarely buy a stock at its bottom, but as long as you build in a satisfactory margin of safety, by buying at a price considerably lower than the stock's intrinsic value, then you'll likely do well. Intelligently assessing a company's intrinsic value is difficult, so investors should demand greater margins of safety to compensate for the uncertainty.

How do you maximize your margin of safety? For starters, avoid messy balance sheets. Leave companies with lots of debt to more sophisticated investors. If you don't feel comfortable assessing whether Wells Fargo has better-quality assets than Citigroup, then just stay clear.

Next, look at well-known, established companies selling cheaply because of temporary problems. For example, retailers such as Home Depot and Lowe's have struggled along with the housing market. But they're both well-run companies and stand to recover nicely once real estate rebounds.

Once you find a great business selling at a good price with a satisfactory margin of safety, don't panic if the stock price drops after you buy. Fluctuations are normal and don't change the intrinsic value. Have patience and conviction in your analysis.