Margin of Safety

With every investment I make, I insist on a margin of safety.  Seth Klarman, a value investor with an amazing track record going back to 1982, wrote an excellent book called “Margin of Safety”.  There are limited copies of the book and it is a favorite amongst value investors.  For these reasons, a new copy sells for $1,300 on Amazon.

Warren Buffett’s mentor Ben Graham wrote a book called “The Intelligent Investor” where he also references margin of safety.  In fact, at one the Berkshire Hathaway Shareholder’s Meetings Warren told us the best two chapters in The Intelligent Investor are Chapter 8 “The Investor and Market Fluctuations” and Chapter 20 “Margin of Safety as the Central Concept of Investment”.  Clearly, margin of safety is an important investment concept, especially for value investors.

So, what do we mean by margin of safety?  In simple terms, it means paying less than something is worth.  Unfortunately, many (probably most) investors have no idea what a stock is worth when they buy it.  They know the current market price, but they don’t know it’s intrinsic value.  It doesn’t matter if a stock trades for $5 or $500--  what matters is what it trades for compared to its intrinsic value (I have included Warren Buffett’s explanation of Intrinsic Value at the end of the document.)

When you buy a stock, you are making an investment in that company as a partial owner.  If you buy a stock simply because it has been going up (this one has a nice-looking chart!) or because it has crashed (hey it can’t go much lower!) then you are speculating, not investing.

When buying a stock, you should look at it the same way as if you were buying a rental property, or a small business.  You would never buy a small business because someone gave you a hot tip and not even look at the competition, the revenue, capital requirements, assets, margins etc.  And you would not be more excited to buy a rental property if the price had climbed significantly the past couple years.

When buying a stock, you should consider a margin of safety for the following reasons:

1.      Greater conviction with your investment which enables you to have the patience for it to be profitable.  Many of my best investments initially fell 30% or more before becoming profitable.  If you buy a stock at $70 with no idea of what it is really worth and it falls 50%, will you really have the conviction to hang on or would you start to second guess yourself and sell it before losing more?  If, however, you buy a stock at $70 and you determined the intrinsic value is $100, you are more likely to stay with it as the price drops.  You might even buy more.
2.      A margin of safety also gives you some wiggle room if you missed something in your analysis or if you were too optimistic with your assumptions.
3.      I have found the more you can remove emotion from the investment process, the more successful you are likely to be.  I have specific guidelines for what I’m looking for in a company, aka a checklist.  Once I find a company that meets my criteria, I estimate an intrinsic value and then I wait for the ideal margin of safety before buying.  For high quality blue chips (Google, Berkshire Hathaway, Coke, McDonalds etc.) my requirement is a 25% margin of safety (e.g. If I think it’s worth $100, I buy at $75 or less).  For my deep value investments which tend to be lower quality companies, my margin of safety is 50%.    

Okay, at this point if you are someone who does not invest in individual stocks you probably don’t care about any of this.  If you are someone interested in buying individual stocks, you might be feeling like this is a lot of work and you are right!  Being a good stock picker and outperforming the market is very difficult.  Roughly 80% of the professionals underperform the market and they are doing this full time with teams of MBAs, powerful systems to capture data, and access to senior management teams.

However, if you enjoy analyzing numbers and have the time to devote, it can be very rewarding discovering a stock with a nice margin of safety, investing a meaningful amount to justify your efforts, and seeing it perform well over time.  As small investors, we have some advantages the big guys don’t have.  We can buy stuff that’s very cheap and unpopular and wait a year or two for it to pay off.  Professionals don’t have that luxury.  They have career risk if they go out on a limb and buy something with a lot of negative headlines.  They also must explain to their clients why they own certain “dogs” in their portfolios so it’s easier for them to simply avoid all the companies that have negative news or problems, but these can be the best investments.      

One recent example that comes to mind is Facebook (FB).  Late last year, it seemed every week there was negative news about the company.  Eventually the stock fell from $210 in July 2018 to a low of $123 in December 2018.  At this point, value investors like me started to get interested in the stock.  If you looked at their financials and ignored the negative headlines, you would see they were still adding users, sales were growing over 30%, and they had tons of cash and no debt.  Even the people who hated Facebook were posting on Facebook to let us know.  Nearly 1/3 of the world’s population uses one of their platforms daily (Facebook, Instagram, WhatsApp).  

As a value guy, FB was always too expensive for me, so I never looked at it.  When I finally did, I was blown away at how impressive their numbers were (growth, margins, cash flow, return on capital, etc.)  Keep in mind, this is a company that does not have to worry about tariffs, raw material inflation, manufacturing issues, or even recessions.  Its unlikely people will drop their service if the economy slows.  Throughout 2019, the news on FB continued to be negative but today the stock is at $194, up 58% from the December low.


My advice to you….

Instead of looking at the companies that are loved and popular and priced for perfection, look at the companies that are getting some negative press and have already seen significant declines in their share prices.  That’s normally where you find opportunities.    








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INTRINSIC VALUE Now let’s focus on a term that I mentioned earlier and that you will encounter in future annual reports. Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life. The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised. Two people looking at the same set of facts, moreover – and this would apply even to Charlie and me – will almost inevitably come up with at least slightly different intrinsic value figures. That is one reason we never give you our estimates of intrinsic value. What our annual reports do supply, though, are the facts that we ourselves use to calculate this value. Meanwhile, we regularly report our per-share book value, an easily calculable number, though one of limited use. The limitations do not arise from our holdings of marketable securities, which are carried on our books at their current prices. Rather the inadequacies of book value have to do with the companies we control, whose values as stated on our books may be far different from their intrinsic values. The disparity can go in either direction. For example, in 1964 we could state with certitude that Berkshire’s per-share book value was $19.46. However, that figure considerably overstated the company’s intrinsic value, since all of the company’s resources were tied up in a sub-profitable textile business. Our textile assets had neither going-concern nor liquidation values equal to their carrying values. Today, however, Berkshire’s situation is reversed: Now, our book value far understates Berkshire’s intrinsic value, a point true because many of the businesses we control are worth much more than their carrying value. Inadequate though they are in telling the story, we give you Berkshire’s book-value figures because they today serve as a rough, albeit significantly understated, tracking measure for Berkshire’s intrinsic value. In other words, the percentage change in book value in any given year is likely to be reasonably close to that year’s change in intrinsic value. You can gain some insight into the differences between book value and intrinsic value by looking at one form of investment, a college education. Think of the education’s cost as its “book value.” If this cost is to be accurate, it should include the earnings that were foregone by the student because he chose college rather than a job. For this exercise, we will ignore the important non-economic benefits of an education and focus strictly on its economic value. First, we must estimate the earnings that the graduate will receive over his lifetime and subtract from that figure an estimate of what he would have earned had he lacked his education. That gives us an excess earnings figure, which must then be discounted, at an appropriate interest rate, back to graduation day. The dollar result equals the intrinsic economic value of the education. Some graduates will find that the book value of their education exceeds its intrinsic value, which means that whoever paid for the education didn’t get his money’s worth. In other cases, the intrinsic value of an education will far exceed its book value, a result that proves capital was wisely deployed. In all cases, what is clear is that book value is meaningless as an indicator of intrinsic value.

Source: Berkshirehathaway.com Owners Manual