In his famous book "Margin of Safety," Seth Klarman (Trades, Portfolio) elaborates on why it is critical to have a margin of safety involved in every investment that we make. As we can recall, the concept was first introduced by who many consider the father of value investing, Benjamin Graham in "Security Analysis."
"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 and 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 will you 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."
So to summarize Klarman's points, we find that as investors, we need to obtain a favorable outcome even when we stress out the variables that could alter the result. That is, even if all goes wrong, we still obtain a gain or at least break even. Second, when there is risk of deflation and prices go down, we have to increase our requirement of a discount in our purchase price. And lastly, and what I believe is a critical factor, we need to ask for a catalyst that will make price converge with its intrinsic value.
Generally as investors, we make the mistake of falling into value traps because we tend to misuse or forget Klarman's three points. Personally, I have fallen into the mistake of thinking that the underlying value is a catalyst by itself, when this is generally not so, and even if it was, there are several opportunity costs associated with waiting for prices to go up. For the second point, I think it is very important to analyze what could happen when the company is forced to lower its prices given the environment. Is there enough flexibility for margins to remain steady? These questions need to be answered before making a decision.