Margin of Safety: A foundational principle of value investing

It’s easy to think that we can pick the right stock, at the right time, for the right price. It’s a tremendous luxury to have auction-driven markets for that very reason. However, every investor must battle with their intuition and fight back against what they think is happening in the macro environment. You can’t always time the market. You may get lucky a time or two with the timing of your entry, which can make you feel as though you're winning. One of the challenges of timing the market correctly is that it inflates investors' egos, making them think it was their intellect that drove the success, all the while, there was a tremendous tailwind at their back. At a Berkshire Hathaway shareholder meeting, a question was asked of Warren on whether or not they hold off on certain investments due to the looming warnings of market corrections or recessions. While I have wondered the same question in my own investing experience, Warren’s answer surprised me. “No, we do not let macro-economic characteristics be the judge on whether or not we invest in any security.” Let’s dive more into what Warren means by that.

              The two most gospel-like ways of thinking about investments come from chapter 8 of the ‘Intelligent Investor’, which talks about how to think about markets, and chapter 20, where it talks about the ‘margin of safety’ concept. What Warren was communicating to the shareholders is a tell-tale way of how top investors see not only investments, but entrepreneurship. The father of value investing, Ben Graham, explains the parable of Mr. Market in chapter 8 beautifully, where every day in an auction-driven market, the market may be pessimistic about the world, or euphoric. He sees the world through a rose-colored lens one day, and then is in a dark room, depressed the next. We ought to view Mr. Market as though he is there to serve us and not instruct us as investors. 

              Besides, the framework on how to think about markets is another nugget originated by Graham, coined the ‘margin of safety.’ The margin of safety is not just a useful concept, but a pillar in sound investing. The idea is to ensure you, the investor, are buying a stock or bond at a significant discount to its intrinsic value, so that even if your estimates are wrong or unexpected trouble hits, you won’t suffer a permanent loss. We went over one of the ways to value a company in the previous posts. According to Buffett, when looking at the quantitative measurements of a business, we first want to have a skeptical lens. The questions should be augmented toward risk. Investing is not about managing risk; it’s about buffering against risk. Remember, the best investments are heads I win, tails I don’t lose (or don’t lose much). Graham writes, “In the ordinary common stock purchase, the investor seeks a margin of safety in the form of a favorable difference between the price paid and the intrinsic value.” Buffett’s analogy is one of the best I’ve heard – basically, think of it like crossing a bridge that can hold 10,000 pounds. You want to cross it with only 6,000 pounds, and that 4,000-pound cushion is your margin of safety in case you misjudge the weight or the bridge’s strength. The point of the Margin of safety isn’t to maximize every penny for profit. What it’s used for is the safety of our principal first, then to have returns second. This is a gut check to ask ourselves, “What if I am wrong? If I am wrong, will I lose big?” The best rule of thumb is to purchase a security for at least 25% off of its intrinsic value. Ideally, the bigger the discount, the merrier. 

The gap between Intrinsic Value and price determines the level of margin you have.

Having a margin of safety can look like a couple of different ways. This could be buying a stock at two-thirds of its book value. Buying a company where there is a huge disparity between the intrinsic value (from earnings) and the price at which it's being sold. Merger arbitrage situation, you name it, there are many different tents in this value investing philosophy. The bottom line is that we want to demand a huge discount on the security we are buying, and not to overpay for optimism.

Life is rich,

Kylan