Margin Of Safety

Value investing is not just about finding stocks that are priced lower than their intrinsic value, it's about having the patience and discipline to hold onto those stocks even when the market isn't recognizing their true worth.

If you were to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.

A principle of investing in which an investor only purchases securities when the market price is significantly below its intrinsic value. In other words, when market price is significantly below your estimation of the intrinsic value, the difference is the margin of safety. This difference allows an investment to be made with minimal downside risk.

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.

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.

Valuation is the closest thing to the law of gravity that we have in finance. It is the primary determinant of long-term returns. However, the objective of investment (in general) is not to buy at fair value, but to purchase with a margin of safety. This reflects that any estimate of fair value is just that: an estimate, not a precise figure, so the margin of safety provides a much-needed cushion against errors and misfortunes. When investors violate [this principle] by investing with no margin of safety, they risk the prospect of the permanent impairment of capital.

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.

Our disciplined risk aversion throughout 2011 enabled us to avoid dangerous temptations and remain focused on investments in our areas of strength and competitive advantage.

The principle is essential in bridge building. Let’s say we calculate that, on an average day, a proposed bridge will be required to support 5,000 tons at any one time. Do we build the structure to withstand 5,001 tons? I’m not interested in driving on that bridge. What if we get a day with much heavier traffic than usual? What if our calculations and estimates are a little off? What if the material weakens over time at a rate faster than we imagined? To account for these, we build the bridge to support 20,000 tons. Only now do we have a margin of safety.

This fundamental engineering principle is useful in many practical areas of life, even for non-engineers.

Firstly, For example, it’s possible to imagine Boeing designing a plane that would have a fail rate indistinguishable from zero, with parts being replaced 10% into their useful lives, built with rare but super-strong materials, etc.—so long as the world was willing to pay $25,000 for a coach seat from Boston to Chicago. Given the impracticability of that scenario, our tradeoff has been to accept planes that are not “fail-proof,” but merely extremely unlikely to fail, to give the world safe enough air travel at an affordable cost. This tradeoff has been enormously wise and helpful to the world. Simply put, the margin-of-safety idea can be pushed into farce without careful judgment.

Secondly, let’s return to the Boeing analogy. Say we did design the safest and most reliable jet airplane imaginable, with parts that would not fail in one billion hours of flight time under the most difficult weather conditions imaginable on Earth—and then let it be piloted by a drug addict high on painkillers.

The problem is that the whole flight system includes much more than just the reliability of the plane itself. Just because we built-in safety margins in one area does not mean the system will not fail. This illustrates not so much a failure of the model itself, but a common mistake in the way the model is applied.