Secret of Value Investment: Margin-of-safety

The concept of "margin of safety" - which originates from Benjamin Graham's earliest teachings - is a core tenet of value investing. All prominent value investors like Benjamin Graham, Warren Buffett, Seth Klarman etc. have given major emphasis on this concept. So, it becomes very important to understand the concept in detail. This article is a try to dig deep.

?What Graham says

Benjamin Graham?and?David Dodd, founders of?value investing and guru of Warren Buffett, coined the term ‘margin of safety’ in their seminal 1934 book,?‘Security Analysis’. The term is also described in Graham's?‘The Intelligent Investor’.

According to Graham, the Margin of safety is a straightforward concept to understand and to implement.?He points out, “All experienced investors recognize that the margin-of-safety concept is essential to the choice of sound bonds.” For example, if you are investing in a bond, you would probably want to make sure that the company has historically generated enough cash flow to cover interest payments and other fixed charges 3 times, 4 times, or even 5 times over in any given year. Graham continues “ This past ability to earn in excess of interest requirements constitutes the margin of safety that is counted on to protect the investor against loss or discomfiture in the event of some? future? decline in net income… The margin above charges may be stated in other ways – for example, in the percentage by which revenues or profits may decline before the balance after interest disappears – but the underlying idea remains the same.” He explained that “the function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future. If the margin is a large one, then it is enough to assume that future earnings will not fall far below those of the past in order for an investor to feel sufficiently protected against the vicissitudes of time.”

What Warren Buffett says

Billionaire investor and the value investment guru, Warren Buffett has given a great emphasis on the concept of ‘margin of safety’. In an article published in 1984, named “The Superinvestors of Graham-and-Doddsville”, Warren Buffett explains the concept of margin of safety referring to his guru Benjamin Graham.?He says “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 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.”

What Seth Klarman says

Seth Klarman, the American billionaire and well-known value investor, is the author of the book “Margin of Safety”. He has explained the concept in his book in great detail. There he explains “Benjamin Graham understood that an asset or business worth $1 today could be worth 75 cents or $1.25 in the near future. He also understood that he might even be wrong about today's value. Therefore Graham had no interest in paying $1 for $1 of value. There was no advantage in doing so, and losses could result. Graham was only interested in buying at a substantial discount from underlying value. By investing at a discount, he knew that he was unlikely to experience losses. The discount provided a margin of safety.” He also adds “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.”

No one can predict cash flows into the distant future with precision, not even for stable businesses with durable competitive advantages. Therefore, any estimate of fair value must include substantial room for error and that room for error is called margin of safety. Though it is well believed that low risk leads to low return and high risk leads to high return, margin-of-safety is a value investment tactic where low risk leads to high return. This is why, another well-known value investor Mohnish Pabrai rightfully says “Most of the top ranked business schools around the world do not understand?margin of safety. For them, low risk and low returns go together as do high risk and high returns. Over a lifetime, we all encounter scores of low-risk, high return bets. They exist in all facets of life. Business schools should be educating their students on how to seek out and exploit these opportunities”.

This is just the online version of the main article published in “Portfolio”, a quarterly magazine of the Chittagong Stock Exchange in its January- March’2018 edition.