Margin of Safety Is Key to Successful Investing

Margin of Safety Is Key to Successful Investing

If I had to choose to teach only one lesson to any investor it would be the “Margin of safety” lesson. Long ago, Benjamin Graham wrote chapter 20 of the Intelligent Investor (Afiliate Link). Quite possibly the most important lesson for any value investor was described in this chapter. Graham covered the topic of “Margin of safety”  which simply put, is to buy a company that is trading at prices well below the value of the business. The difference between the price paid and value received is your margin of safety. The larger the margin of safety the better the investment. Maintaining a large margin of safety is not about putting the probability of being right in your corner. It is, however, used to protect you from massive losses. Investing for a long period of time is sometimes more about avoiding losses than finding winners.

Before we dig right into margin of safety it is important that we understand the two terms that makeup margin of safety price, and value.

Price

Price is something that is hard to fully understand. The efficient market theory says that all knowledge is priced into a security. To me, the EMT is a load of BS. Price is what an asset is marked at during a specific point in time. Just like grocery stores, prices change all the time in the stock market. Sometimes there will be huge markups and you won’t buy apples that week. But sometimes there are situations when you buy a bunch of toilet paper because they are on sale so low that it would be stupid to pass up the opportunity.

Both of these situations are present in the stock market. There are companies that are priced so high relative to their value that you would rather pass than buy them, even though you may like the company. Then there is the opposite, a company will be priced so low compared to value that you are getting a steal so you buy as much as you can.

The tricky thing with price is that it is elusive and has no boundaries. It can be as high as it wants to be or it can be lower than you can imagine. The point is that it is always moving. In the stock market, there is one main reason for the massive swings in prices we see often on a monthly basis; the psychology of investors. Investor psychology is the main culprit for companies pushing all-time highs along with prices becoming cheaper than dirt. Usually, the psychology of an investor is affected by news and popularity on a short-term basis.

It is unfortunate but the stock market is a big popularity contest in the short term. The new flashy tech companies will be the ones that return 50-100% returns for the year. Returning larger yields than better companies simply because they have more curb appeal. For example: what do you think people will be more interested in, Tesla (TSLA) or Waste Management (WM)? It’s a no-brainer. Even though WM is possibly a more certain investment due to the nature of their business more people will look Tesla’s way. It’s sad but for value investors this is good. It means that they are able to get invested in great companies for less. Sometimes being a dirty (pun intended) company can be great opportunities for investors.

“If investing is entertaining, if you’re having fun, you’re probably not making any money. Good investing is boring.”-George Soros

The truth is that if you are only looking where everyone else is looking you will find yourself chasing the crowd. This effort will leave you with nothing but average results and possibly lower results. Great investing is boring, there are no 50% run-ups in great value investing. I am sorry but if you expect to make a solid return on your money that is dependable, expect it to be boring.

You can always go try your luck with the hot stocks of the year but commonly these companies will leave you with losses. The crowd loves hot stocks and will push up the prices sky high, but what happens when the crowd leaves? Its great to be invested in something that is loved by everyone but when your potential returns are in the hands of the crowd expect them to let you down. There will be times when you might see a run of price when you first get invested but once everyone finds other hot companies they will leave the old companies and the price will follow. You do not want your returns in the hands of others.

When you look to invest price is the largest portion of the equation. It will set you up either for large returns, average, or losses. The issue is that usually, the potential returns are the greatest when companies are at their lowest prices reflecting the unpopularity. When no one wants to touch it, is usually the best time to pick it up.

When you go to buy a car do you look at the price? I hope so. The same thing goes for investing. There are no assets out there worth any price just like there is no car worth any price. You wouldn’t buy a used car with 250,000 miles on it for $40,000. There are prices appropriate to the value of everything, even businesses.

The great thing about the extremely fluctuating prices is that sometimes things can become on sale for unimaginable prices. They make no sense what so ever, just like Mr. Market can price companies sky high, he can also give investors opportunities on dirt cheap companies. For value investors this is the holy grail when an excellent company is priced well below its perceived value it can be a great investment. This leads me to my next point.

Value

Value is the other portion of the equation that is the benchmark used to compare the price too. Remember the wise words of Mr. Buffett “Price is what you pay, value is what you get.”. Its common mistake of many to clump both price and value together. These are two totally different things and it would be one of the deadly sins if you decided to look at both price and value with the same mindset.

Like we covered above price is something that can be ever changing. It is in constant motion. Value is not like that. It is not something that will change rapidly. Plus, it is hard to put an exact number on value. But that number, whatever you deem acceptable doesn’t change as rapidly as price. Let me ask you this; if a company releases earnings and they missed revenue by a few basis points (1 basis point is .01% so 100 basis points = 1%) and the stock drops 25%. Does the value of the company drop 25% also? Of course not. It would be idiotic to think that the value of a company would decrease in a matter of 24 hours. These are the overreactions of the market that can be very profitable for an intelligent investor.

Unlike price, we can not put a specific number on value and sometimes value can be a good thing and other times it can be a bad thing. It all depends on the business. All relative information goes into determining the value of a company. A company in a dying industry does not have favorable value. On the other hand, a company in a favorable industry and has an excellent business model can have great value. It is all relative to the business itself.

Like I said before we can not put an exact number on the value of a company. It is almost near impossible. If 2 people are placed in a room and are asked to determine the value of a company the probability that they will come up with the same number is extremely low. Because value is such a broad topic I will talk about the type of value many intelligent investors use when looking at public companies, intrinsic value.

In a simple definition, intrinsic value is the total value of the company including both the tangible and intangible assets. When we say tangible we mean physical items like buildings and inventory. Intangibles are things like the price tag of a brand, which is extremely hard to put a number on. Intelligent investors understand that intrinsic value is like value, it doesn’t have a specific number assigned to it.

Investors will instead identify the range of value, this puts less pressure on trying to be perfect and allows for mistakes or miscalculations. Placing a range of intrinsic value is something we actually do as humans more often than you might think. For example, when a woman walks into a restaurant you are able to tell pretty quickly if she is old enough to buy beer or not. That is the type of range intelligent investors use when investing. They don’t try and place a dead set age on the woman they give it a range.

Another tricky thing is that like I said before everyone has their own way of calculating intrinsic value. Each investor has their own way. I wish I could sit here and give you a formula that would spit out an exact number for intrinsic value but I can’t. Honestly, there is no one out there that can do that for you. I talk about in my post about the criteria I look for in investments. It talks a little bit more about intrinsic value and the Benjamin Graham formula.

The great part about being an investor is that there are times when the price of a company in the public market might fall below its relative intrinsic value. When this happens it can be to the advantage of the investor to purchase the security. The difference between price and value presents us with the main topic of the article the “margin of safety”. By the end of this section, your investing knowledge will be at another level.

Margin of Safety

Margin of safety is going to be the way to protect you from permanent loss and sometimes that can be a better focus than thinking about the returns you can make from an investment. Like I stated briefly above, a margin of safety is created when the price of a security drops below the intrinsic value of a company. When that happens it can truly be magical. Don’t jump the gun yet though, the foolish thing to do would be to buy every investment you think is undervalued. Remember everyone who buys a stock has some idea that the value of the company will be worth more in the future. That is what the crowd does and if we have learned anything, it is that the crowd does not lead you to success. The thing that separates the men from the boys is the amount of margin of safety in each investment.

As the price drops lower and lower below the intrinsic value the larger and larger the margin of safety becomes. The best investors like Warren Buffett always wait for the margin of safety to be the largest. The amount of patience it takes to wait for that opportunity is unmatched. Think about it like this: when prices are dropping and dropping the overall popularity of the stock is going down. This usually means you will hear nothing but bad news about the company. As an intelligent investor, the mental strength needed during these time needs to be at a high. You have to be willing to buy something that everyone deems bad and awful. It takes great patience and mental fortitude to be able to capitalize on these types of investments. It is hard to do, which is why we only see a few very successful investors. There is no specific margin of safety amount that is set in stone but make sure it is large. I like to look for companies trading at least 25% below their intrinsic value. That way, if I am 10% wrong in my calculation of intrinsic value I still have a 15% upside.

If there is one lesson that I have learned it is there is no such thing as a perfect business. They all have a price point acceptable for investment. The biggest problem with individual investors is they believe that is it acceptable to buy a great business at any level. Even though there are worse things in the world of investing. This type of buying is not investing, it is speculating. Investing involves calculated decisions and extreme patience. Speculating is buying any item at any level hoping that the company will carry the price into the future.

Everything involved in investing begins with the price you pay. One opportunity might seem attractive at one price but doesn’t seem that good at another. Like I said before you would never buy a car without knowing the price, so why in a million years would you make an investment any other way? The price of the investment is the starting point and it should help you decide if now is the time to buy or not.

I know this topic can get a little hairy. When you start to think about price it can lead you to think we are trying to time the market. That is not how I want you to think about it. When you are looking at an investment we weigh two things. The price you pay and the value you receive.  If the value, you receive is less than the price you pay it is not worth the investment. But when the price you pay is less than the value you receive you have yourself an investment. By saying no to an investment because the value is not enough you are bypassing a speculation, good job.

Investing is all about the patience you exercise. There are very few occasions when great companies have a large margin of safety to them. It requires a great deal of patience to allow these opportunities to fall into place. Then when they do you take full advantage of them. The real reason why Warren Buffett and other great investors are so successful is more about their ability to wait for the right opportunity rather than their ability to select great companies (Even though he is really good at that too).

Sometimes the best quality an investor can have is his ability to be patient and picky. If we truly want to have success in the stock market we need to embody both of these characteristics. Investing is more about saying “No” then it is saying “Yes”. As you begin to say “No” more and more to opportunities you develop this pickiness for opportunities that you like. Then when you do find something you really like the more confident you will be with your investment. We all have to think of investing as baseball and only swing at strikes that are right in your sweet spot. Unlike baseball, you can watch strike after strike goes by. There is no limit.

Waiting for your fat pitch is what will determine your investing success. The fat pitch should entail a large margin of safety. Without it your putting yourself at a larger risk. The biggest thing that we all need to realize is that our decision making can be wrong. Nothing is for certain. By making sure we have a large margin of safety we make room for error. The greatest thing about margin of safety is, even if we are wrong we have taken the steps necessary to protect us from a catastrophic loss. By letting investments come to us instead of chasing them we are putting our self in spots of likely investing success rather than loss or minimal return.

It is much better to sit and patiently wait than to rush into the game and make a huge mistake. The stock market is so liquid that we often feel the need to be liquid with it, continuingly moving in and out of investments. Instead of focusing on the price day to day put more focus into building up your capital funds for the special time when the economic skies do open up and rain gold. It’s better to have a lot of cash at the bottom than at the top. I personally have shifted my mindset to this and I am never going back. Time is a good thing for a great business, we only invest in great businesses so allow them to work.

If you follow all of the appropriate steps for investing like only buying great businesses with a large margin of safety then your investment life will be much better. After you are done buying, it is time to sit back and let them work for you. Margin of safety will save you a lot of stress and money.

In Closing

The lesson taught in chapter 20 of The Intelligent Investor is quite possibly the most important lesson ever taught to inevstors. It teaches you that a price is merely a number and value is what you actually receive when you buy a company. I wish I could have learned this lesson before I began investing but I have learned it now. If you follow these appropriate steps you will see more success than I did when I started out.

The best thing an investor can have is a set of principles they live by and come hell or high water they do not venture away from them. One of those principles should be maintaining a large margin of safety. This principle will save you a lot of time and money. By promising yourself to never invest unless there is a large enough margin of safety you will become picky which in the end can be the best gift an investor can get. Saying no to more investments means that when you find that special one it will be just that, special. I hope this helped you understand the whole topic of margin of safety, implement it in your investing life and I promise you won’t be disappointed.

Peace and Love,
Michael


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