“Margin of safety” is something that you will hear investors talk about all the time.
Having spent a lot of time researching and refining margin of safety over the years, I have come to the conclusion that most of them don’t actually know what the hell they are talking about.
There are several facets to investing with a margin of safety and if you don’t pay attention to all of them you are NOT maintaining any margin of anything, much less safety.
In engineering, a margin of safety is easy to understand.
If a bridge is going to have a 10,000-pound truck driving over it every day, design it to carry several 20,000-pound trucks at once. If a building is in Miami and can be expected to undergo 150 miles per hour hurricanes a few times, design it to withstand sustained 250 MPH storms.
In other words, build to experience a multiple of the worst-case scenario.
As an investor, as you begin analyzing an opportunity, you have to ask yourself a very blunt question:
A “Low Price” Alone Is No Guarantee Against A Disaster
The last chapter of Benjamin Graham’s classic The Intelligent Investor (quit pretending you have read it and buy a copy today. Your account value will thank you for it) is titled “Margin of Safety as the Central Concept of Investment” and he writes that “Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY. ”
Graham’s most successful student, Warren Buffett, has talked frequently about this idea and defined it thus:
“You have to have the knowledge to enable you to make a very general estimate about the value of the underlying business. But you do not cut it close. That is what Ben Graham meant by having a margin of safety. You don’t try to buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And that same principle works in investing.”
Far too many have adopted that to mean that if you could just buy a business at a low price, you had a margin of safety.
That’s far too simplistic.
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What if this business you bought was a buggy whip manufacturer around the time the automobile was introduced?
And you probably could have gotten a great bargain purchasing a company that made VCR tapes in the 1990s.
We have to dig deep into the company and make sure it can thrive, and we don’t lose money that we can never get back.
We have to use margin of safety the way bond investors use the idea. We have to dig into the credit profile of the company and ask some basic questions.
Can this company generate enough cash to pay the bills and grow the company? Will they survive a recession without going under? What is the worst thing that can happen and will the company exist if it occurs? Can they survive until they thrive?
When considering banks and other financial institutions as investments, we have to add some questions.
We need to look at the loan portfolio to see if they are maintaining prudent lending guidelines. Do they have lots of excess capital to weather the inevitable storm? Are they shifting their loan and investment portfolios into areas where they have little to no experience to pick up a few extra basis points of yield? Nothing sends me running for the hills faster than seeing a bank that has always been a mortgage lender expanding into consumer and industrial lending to raise their short-term returns or a life insurance company deciding to write car insurance.
The final component is the price to value equation. There is little to no chance of Amazon (AMZN) going out of business anytime soon, but it is very easy to see the company dropping to the point investors will be many years getting back to even. Investors in companies like Cisco (CSCO) and Microsoft back in the late 1990s probably understand margin of safety better than most. Investors who bought Microsoft in 1999 did not get back to even until late 2017 and those who purchased Cisco still need to see the stock go up by roughly 50% to be even.
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Here’s Exactly How to Find The Margin of Safety (For Any Investment)
In his classic book Margin of Safety, Seth Klarman defined the concept as he has used it to rack up enormous returns for investors. He wrote that “By always buying at a significant discount to underlying business value, and giving preference to tangible assets over intangibles. 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.”
I always use several valuation models when I look at a company.
- I look at the business valuation model most used by private equity investors (by far the most successful investors as a group).
- I look at price to cash flow.
- And I look at earnings before interest and taxes.
- I then run the numbers through a discounted free cash analysis to see what that number tells me.
- I also still look at price to net asset value. Although modern finance tells us this number is no longer relevant, I have found that, especially for financial companies and real estate related ventures, it can still an incredibly accurate reflection of corporate value.
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If we put all this together, finding a margin of safety has three steps:
1. Is this a good business? What’s the worst thing that can happen and do they generate enough cash to survive until they thrive again?
2. Are they in a strong financial condition and ability to pay their bills and keep the doors open if something does go wrong? Are there any signs of someone doing something stupid that will destroy the value of the business?
3. Am I paying a discount to the actual value of the business?
If you are not starting every investment by considering the margin of safety concept, history tells us you probably won’t make as much money as you should be. If we take care of the downside, history speaks again, telling us that the upside will pretty much take care of itself.
To the Max,