Warren Buffett has often stated that the Intelligent Investor by Benjamin Graham is the best book ever written on investing. The two chapters Buffett rates most highly are chapter 8, “The Investor and Market Fluctuation,” where Graham came up with the metaphor of the manic-depressive Mr. Market, and chapter 20, “Margin of Safety as the Central Concept of Investment.” The focus of this text is the latter.
Margin of safety as a concept
“Long ago, Ben Graham taught me that “Price is what you pay; value is what you get” -Warren Buffett
Margin of safety is, in investment terms, often described as the difference between value and price. If the value is significantly higher than the price, there is a margin of safety. Some academics think that value and price are equivalent and that the price always reflects its true value. Furthermore, short-term-minded speculators solely focus on the price and its trend as a means of outperformance. Value investors focused on fundamental analysis see a major discrepancy between the two, which is the basis for their profession. To understand the concept of margin of safety, one must understand the value of a business and how it can be estimated. Graham expertly relates the concepts of valuation and margin of safety in the Intelligent Investor:
“Valuation is the closest thing to the law of gravity that we have in finance. It’s 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.”
The chapter on margin of safety is short and packed with wisdom. After Graham wrote this famous chapter, many value investors, including most notably Buffett, have used the concept as a cornerstone of their investment philosophy. Buffett’s partner, Charlie Munger, describes how redundancy is widely used in engineering but overlooked in the financial world: “In engineering, people have a big margin of safety. But in the financial world, people don’t give a damn about safety”. Buffett has also related it to the field of engineering, where he describes that it’s essential to make sure that a building or a bridge is significantly stronger than what is needed in a worst-case scenario: “When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And the same idea works in investing.” Buffett doesn’t specify how large the margin of safety shall be compared to the intrinsic value as it depends on the uncertainty in each situation. Both he and Munger want the margin of safety to be so large that there is no need for a calculator to figure it out.
In his excellent blog Farnam Street, the author Shane Parrish presents the margin of safety as a mental model rooted in engineering and quality control. Parrish brings up an example of a jet engine part designed for 10,000 hours of flying. The airplane may experience harsh flying conditions, the engine part may have suffered from a slight flaw in manufacturing, or the assumption to come up with the 10,000-hour figure may have been optimistic. Due to these and other factors, a decision will be made to change the jet engine part after 7,500 hours of flying, where 2,500 hours consist of the margin of safety or margin for error. “Margin of safety is an important component to some decisions and life. You can think of it as a reservoir to absorb errors or poor luck. Size matters. At least, in this case, bigger is better. And if you need a calculator to figure out how much room you have, you’re doing something wrong.”
Seth Klarman is another highly regarded investor who has popularized the use of a margin of safety, having written a book with the name. In his book, he writes: “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.” In the last version of Graham’s bible on investing, Security Analysis, which Klarman edited, he wrote: “Investing in bargain-priced securities provides a ”margin of safety” – room for error, imprecision, bad luck, or the vicissitudes of the economy and stock market.“
In short, the meaning of a margin of safety within investing is that the value should be sufficiently greater than the price. There should be room for error in the analysis so that the investor will come out ahead even if unexpected events happen, which is the rule rather than the exception. In the words of Graham: “It is available for absorbing the effect of miscalculations or worse than average luck.”
Measuring the margin of safety
By studying the evolution of Graham and many of his followers today, one major distinguishing factor is the use of a quantitative versus a qualitative approach to investing. Graham and his disciples often describe the concept of a margin of safety as a quantitative measurement. By learning from the most successful value investors in recent times, it’s clear that a margin of safety can also be rooted in a business’s qualitative aspects. The margin of safety depends on the specific situation. What makes it challenging to figure out is that none of the two overall parameters that form the margin of safety is static. The value typically changes slowly and is a subjective measure, while the price changes quickly and is an objective measure. Discrepancies between value and price can be large in both directions over long periods but temporarily converge when the market gets it right and thereafter diverges again. However, as all investors will likely differ at least slightly in their intrinsic value calculations, they will also differ in their margin of safety calculations.
As humans, we have a bias to want to measure things precisely. When searching for material on margin of safety, it’s striking how many quotes and thoughts there are around the specific size of the margin of safety. Investors want to know a percentage figure to put in their spreadsheets. Some argue that there should be a difference of fifty percent between value and price; others think it shall be thirty percent, while some state that it’s part of a conservative fair valuation considering all factors. As shown in the efficient market hypothesis, people are fond of being able to quantify everything to the closest detail. At the same time, the value of that in the area of investment and other complex adaptive systems is often small or even harmful.
Practical use of the margin of safety
To give you some flavor on how to use the concept of margin of safety in practice, this is how Benjamin Graham describes it in the Intelligent Investor:
- A margin of safety for bonds and preferred shares is that a company, in this case, a railroad, should earn five times its total fixed charges over a period of years in order for it to qualify as investment grade.
This method can be used by bondholders and holders of equity to understand the quality of the business without considering the price. It could also be used to rank stable businesses in terms of the risk of suffering losses as a bondholder. The larger the interest coverage, the larger the margin of safety.
- Another way is by comparing the total value of the enterprise with the amount of debt on the balance sheet.
If a company is fairly valued at 100 million and has a debt of 30 million, there is much room for shrinkage before the bondholders will suffer losses. This involves valuing the business and comparing it with the debt situation. As the bondholders are first in line in bankruptcy, they can feel relatively safe if the value of the business is significantly larger than what is owed.
- If a company has the possibility to take up more debt than the total company is selling for.
This method considers price and compares it to the amount of debt the company can take on. This is highly connected to the first method, which focuses on interest coverage. An often-used multiple is also to compare the net debt of the company, often measured as interest-bearing debt plus unencumbered cash, with the enterprise value. The multiple for the business can be set by copying the ratio for the industry. The value for the shareholders can be realized in a maneuver where the company takes up the additional debt and issues a dividend and/or buy back stocks for the full amount to or from its shareholders and thereby creating more value than its former selling price warranted. An investor who has mentioned the practical value of this method is the professor and fund manager Sanjay Bakshi, who uses it as one of the tools in his investment toolbox.
- To compare the earnings power of a stock with the bond rate.
If the normalized earnings yield is 9% and the bond rate is 4%, the annual margin is 5%. Over time, this excess leads to a significant difference which the long-term investor can take advantage of. What is of essence is to be conservative when calculating the normalized earnings yield in order to avoid diminished earnings power. Graham thinks that the company needs to have shown stable earnings over several years to qualify as earnings power, as the company may benefit from temporary fortunes. “Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.”
Buffett has repeatedly emphasized this in his shareholder letters and speeches to describe the edge that stockholders have over bondholders in the long run. The earnings yield is the inverse of the price-to-earnings multiple (P/E). A common method to value a business is to compare the current P/E with the “normal” P/E. In this example, the normalized earnings yield is compared with the bond rate to understand the attractiveness of bonds versus equities.
Graham was very focused on the balance sheet, and the first three methods involve the company’s financial situation and focus on debt. None of the examples presented in Graham’s chapter on margin of safety brings up the classical method of setting an intrinsic value to a business, reducing the value with a margin of safety, and comparing it with the price. That is another way of doing it. Buffett has described that he thinks the value of a business consists of the present value of its future net cash flows, which John Burr Williams first described in his legendary book The Theory of Investment Value written in 1937. In his shareholder letter of 1992, Buffett wrote the following about how he makes an estimate of the intrinsic value of a business and how it’s linked with a margin of safety:
First, we try to stick to businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change, we’re not smart enough to predict future cash flows. Incidentally, that shortcoming doesn’t bother us. What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know. An investor needs to do very few things right as long as he or she avoids big mistakes. Second, and equally important, we insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we’re not interested in buying. We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.
Buffett’s description is related to the classical method of incorporating a margin of safety which is mentioned above. First, he values a business by setting an interval to its worth. Then he compares it with the price. He emphasizes that he only tries to value the businesses he understands, the ones within his circle of competence. If it’s outside the circle, he can’t set a reasonable value, and then he doesn’t have anything to compare the price with. Buffett doesn’t offer any specific guidelines for the size of the margin of safety more than that the value needs to be significantly higher than its price. This comes back to the earlier description that he does not need a calculator to figure it out. The decision shall be a “no-brainer,” an often-quoted description by Mohnish Pabrai, a successful fund manager and friend of Buffett and Munger.
Growth and quality as factors
Graham is often described as an investor who didn’t value growth as much as typical value parameters. That this was true can be exemplified by the investment method he employed, which was focused much more on the current value as measured by the figures on the balance sheet than the possible future value of businesses. He thought that others with a special degree of foresight and judgment could prosper from investing in growth stocks and that growth stocks may supply a margin of safety if the estimates on the future are conservative and if the stock showed an adequate margin to the price paid. What he points out is that the market often favors these stocks and thereby sets prices that can’t be warranted by conservative estimates of future earnings. “The margin of safety is always dependent on the price paid. It will be large at one price, small at some higher price, nonexistent at some still higher price.”
Some successful value investors of more modern times disagree with Graham’s focus on cheapness based on quantitative measures. One of them is Charlie Munger, who thinks that Graham had a blind spot in missing that some businesses are worth paying a premium for. Munger is famous for helping Buffett to understand the value of fantastic businesses “Charlie showed me in the direction of not just buying bargains, as Ben Graham had taught me. This was the real impact he had on me. It took a powerful force to move on from Graham’s limiting view. It was the power of Charlie’s mind. He expanded my horizons”.
Over the last ten years since the financial crisis, value strategies incorporating growth have outperformed traditional deep-value strategies focused on values on the balance sheet. Buffett and Munger emphasize that they see growth as just another value factor, and especially Munger has been vocal. In an interview after the 2018 Berkshire shareholder meeting, he mentioned that “all intelligent investment is value investment.” For the following discussion, I will use the terms growth and deep value to distinguish the methods.
There are certainly many ways of describing why growth has outperformed, but some of the ones that I think are most credible are:
- Structural changes due to digitalization
Traditional deep-value strategies often focus on finding businesses with temporary problems that will reverse back in the future. History is filled with examples where businesses in slow-growth cyclical industries get punished too hard in bear markets and gets rewarded too highly in bull markets. What if the industry has fallen into a structural bear market, though? Businesses within the sector will then be value traps.
How was it possible to understand if a service was good or bad before the internet and the services that have been provided due to the internet? Surely, marketing had a more important role then. It’s almost impossible for me, who has been brought up with the internet, to picture a world without rating services such as TripAdvisor and Yelp, as well as information that can be found using Google or Facebook. It’s a natural way of doing business to conduct due diligence on the internet before buying something today. The retail sector has got punished when people are going to traditional stores to try out clothes or furniture and then look up where it’s cheapest online instead of buying in-store. The brick-and-mortar stores have been slow to adjust to this reality and have not found ways of capitalizing on the value they still give consumers. Companies within the sector have subsequently been punished hard. Many of these companies have looked cheap based on deep-value strategies but have been value traps during the last years. Furthermore, when consumers can compare products based on what other people think instead of being bombarded by commercials, the value of many brands has arguably been punished. Digitalization has led to large changes in consumer behavior which has been a significant disruptor for investors.
- The low-interest environment
Growth stocks are valued at expected future earnings, while value stocks are valued at current earnings. As interest rates decrease, the value of both current and future earnings rise but with a higher impact on future earnings discounted far out in time. This reverses itself when interest rates rise, which has been confirmed in 2022.
Diversification
Another area where more growth-oriented investors, such as Munger and Philip Fisher, differ from Graham is their view on diversification as a source of a margin of safety. They have emphasized that the investor should hold a small number of stocks that he or she understands and hold them for as long as they keep performing. Of course, this doesn’t mean that they recommend investors to hold only one or two stocks but instead closer to five to seven. Graham sees diversification as tightly connected with a margin of safety, as an individual stock pick can work out badly despite a margin of safety. You could argue that diversification is a second layer of defense to cover for negative low-probability events. Graham recommended between ten to thirty stocks to get sufficient diversification.
To Graham’s credit, he emphasized that “investment is most intelligent when it is most businesslike” and that it’s essential to “know what you are doing – know your business.” He wholeheartedly agreed that the investor needs to understand the businesses; he just thought the investor needs more than ten stocks to achieve the necessary diversification. Arguably investors need to figure out the level of diversification where they are comfortable by themselves as it depends on how much effort the investor puts into following the businesses, the investors’ clarity of thought, and individual risk preferences. There are many stories about investors that have gotten rich by using either a high degree of diversification or a low degree of diversification. Some of the most notable names in the first category are Peter Lynch and Sir John Templeton, whereas the other category consists of Munger, Fisher, and Buffett. The jury is still out on which way is the best, and I wouldn’t expect a quick resolution to that debate.
Concluding remarks
Value Investing, or intelligent investing in Munger’s terms, has evolved during the 20th century. Deep-value strategies have outperformed growth strategies over some periods and vice versa. Some investors have prospered by using a high degree of diversification, while others have prospered with a low degree of diversification. A more recent trend has been the shift from qualitative to more quant-driven strategies. Despite this evolution, some things have stayed the same. The concept of a margin of safety has stood the test of time and will most certainly be a valuable tool for the serious investor in the 21st century and onwards. The method of incorporating the margin of safety has changed and will always have to evolve to fit the current reality.
On that note, I will end with a quote from James Montier in his fabulous text The Seven Immutable Laws of Investing: ”A true margin of safety is one that can be demonstrated by figures, by persuasive reasoning and by reference to a body of actual experience.”
Niklas Sävås