Lesson #17: Margin of Safety

Value Investing Masterclass - Safal NiveshakBefore we move ahead into this lesson, just answer Yes/No to these five simple questions:

  1. Do you own an insurance policy?
  2. Do you save money?
  3. Do you keep extra cash (more than you will need) with you when you travel?
  4. Do you reach the railway station an hour before the scheduled departure of your train?
  5. Do you believe that prevention is better than cure?
  6. If you answer ‘Yes’ to all or most of the above questions, you are a practitioner of ‘margin of safety’.

You keep some extra time and money on your hand in case things do not go as planned – like if you run out of cash during your travel, or you get stuck in a traffic jam while going to the catch a train.

The same ‘margin of safety’ applies even to stock market investing.

“If you were to distil the secret of sound investment into three words”, wrote Benjamin Graham in Chapter 20 of The Intelligent Investor, “we venture the motto, MARGIN OF SAFETY.”

Graham’s margin of safety is the difference between a stock’s price and its intrinsic value. In theory, the further a stock’s price is below its intrinsic value, the greater the margin of safety against future uncertainty and the greater the stock’s resiliency to market downturns.

In his speech – The Superinvestors of Graham-and-Doddsville – Warren Buffett defined margin of safety as “buying 1 dollar for 50 cents.”

Buffett said…

You also have to have the knowledge to enable you to make a very general estimate about the value of the underlying businesses. But you do not cut it close. That is what Ben Graham meant by having a margin of safety.You don’t try and buy businesses worth $83 million for $80 million. You leave yourself an enormous margin.

When you make an investment the laws of probability apply since the decisions involves risk, uncertainty and ignorance. Many people make the mistake of assuming that buying a quality business ensures safety.

As Howard Marks puts it best in his book The Most Important Thing…

…most investors think quality, as opposed to price, is the determinant of whether something’s risky. But high quality assets can be risky, and low quality assets can be safe. It’s just a matter of the price paid for them….Elevated popular opinion, then, isn’t just the source of low return potential, but also of high risk.

Similarly, just because the price of share of stock in a company is beaten down from formerly high levels does not make it “safe” to buy.

The margin of safety concept is about making it likely that you have the odds significantly in your favour by trying to find a substantial cushion in terms of the odds.

Value investor Seth Klarman in his classic book Margin of Safety writes…

Because investing is as much an art as a science, investors need a margin of safety. A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable, and rapidly changing world.

According to Graham, ‘The margin of safety is always dependent on the price paid. For any security, it will be large at one price, small at some higher price, nonexistent at some still higher price.’

Warren Buffett describes margin of safety concept using this example – “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.”

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How much margin is good margin?
Coming again to the question of what is an adequate margin of safety, the answer varies from one investor to the next. But it chiefly depends on –

  1. How much bad luck are you willing and able to tolerate?
  2. How much volatility in business values can you absorb?
  3. What is your tolerance for error?

In short, it all boils down to how much you can afford to lose.

Losing some money is an inevitable part of investing. In fact, there is nothing you can do to prevent it.

But to be a sensible and intelligent investor, you must take responsibility for ensuring that you never lose most or all of your money.

If you think you cannot afford to lose much from your stocks, it always pays to have a good margin of safety, say around 30-40%. This means that you must buy Rs 100 stock for not more than Rs 60-70.

Using the margin of safety concept, and by refusing to pay too much for an investment, you minimise the chances that your wealth will ever disappear or suddenly be destroyed.

What you are trying to do when making an investment is to find a mispriced bet. What margin of safety is all about is finding a “significantly” mispriced bet.

Seth Klarman writes…

A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world.

The bad news for some people in all of this is that investing is hard. But the good news is also that investing is hard and if you have the right temperament and are willing to do the necessary work the process can be fun.

To better deal with inevitable mistakes we all make as human beings, you should have built into the process a “margin” of sufficient size which ensures that even if mistakes happen the outcome will be “adequate”, as Ben Graham describes.

To quote Munger again…

In engineering, people have a big margin of safety. But in the financial world, people don’t give a damn about safety. They let it balloon and balloon and balloon. It’s aided by false accounting.

When engineers are building a bridge, they ensure that it is significantly stronger than necessary to deal with the very worst case. The same principle works in investing.

So, insist on a margin of error or margin of safety in your purchase price. If you calculate the value of a stock to be only slightly higher than its price, don’t be interested in buying.

This margin of safety principle, so strongly emphasized by Ben Graham, is and would always remain the cornerstone of investment success…your investment success.

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