Margin of Safety, Expanded
May 01, 2010Quite possibly the most influential thought leader in the history of investing, Benjamin Graham wrote three words that have echoed in the minds of the world’s greatest investors for the better part of a century now. Three words that describe a concept so simple, yet so profound, that it can be expanded beyond security selection and investment strategy to prudent management of all of one’s personal financial affairs. From the master’s own pen: “Confronted with the like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.” Originally used as part of the criteria for defensive stock selecti on, margin of safety (M.O.S.) was calculated as the gap between the intrinsic value of the stock and the market price at which an investor could purchase it. Bear with me for an explanation of its initial use, and then we’ll consider the application for the rest of us. For example, a stock analyst might evaluate Company X stock and determine that the estimated value of the delivery trucks, office buildings, and other physical assets plus a conservative calculation of earning power indicated a per-share value of $82.
This intrinsic value is meant to approximate the economic value of Company X to a private owner. The investor could then compare the intrinsic value of $82 to the current market price, say $68 per share, to determine if and to what extent there exists a margin of safety. In this case, the margin is $14 or 17%. Graham looked for margin of safety in the 30-50% range before he considered purchasing a stock. In other words, he wanted to find a dollar of value that could be purchased for 50 cents. To fully comprehend the significance of this, we must consider that such opportunities do not come along every day — in fact, they are rarer than most people would believe. Understandably, it is difficult to get reasonable people to part with assets (remember you need a buyer and seller) for 50 cents on the dollar. Why, therefore, insist on such a large margin? In Graham’s words, “the function of 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.”
Expanding the Application – M.O.S. for the Rest of Us
Most of us do not spend our days analyzing stocks and bonds. However, above-average investors (Brightworth clients, readers of this publication, etc.) must apply Margin of Safety to cash flow management, AND utilize it in building out a framework for their investment portfolios. For example, Brightworth clients are generally advised to keep at least 5-8 years worth of cash flow needs in bonds and short-term securities. This creates Margin of Safety in a family’s operating cash fl ow. This is critical to weathering through the financial surprises life brings your way. This one principle could have made the difference for many of the wealthy people who filed bankruptcy due to lack of cash flow this past year. Further, proper grasp of margin of safety gives an investor the much-needed emotional fortitude to make the right decisions during market turmoil.
From Graham we get two broad benefits of the concept. First, Margin of Safety thinking eliminates the need for “accurate esti mates of the future.” Everyone has an opinion about the future. In fact, it is hard to fi nd someone (expert or novice) who can’t share two cents on “where the market’s headed” or “how long it will take the economy to recover.” Given the horrible track record of these prognosticators, what amount of your financial future do you really want to depend on accurate guessing? M.O.S. thinking builds in a substantial cushion to cover the shorter-term periods that allows you to build your financial strategy on time-tested principles. You will occasionally miss out on a hot sector, but that is a small price to pay to avoid being wiped out by a bad guess at the hot sector!
The Vicissitudes of Time
Margin of Safety eliminates the need for accurate estimates of the future, but also protects against the “vicissitudes of time.” In other words, with proper margins (in our cash flow, thinking, analysis, etc.) we can weather through the inevitable, inexorable eff ects of change. Wars, pestilence, famine, global warming/cooling/moderating, or even just the business cycle — all bring change. “Since 1790, the U.S. economy has experienced forty-six business cycles. Time and again people came to believe that business cycles had been banished, only to be surprised by a new recession. No sooner had Mark Twain written about the ‘Gilded Age’ in 1873 than a depression enveloped the economy. In the twentieth century alone, we’ve seen three periods hailed as ‘New Eras’ … It is from these heights of certainty what we tend to crash to the depths of despair, where risk seems to lurk around every corner. Neither extreme is realistic.” ("Beating the Business Cycle" by Achuthan and Banerji)
M.O.S. thinking also identifies hidden risks created by a mismatch of investment objectives. For instance, if your cash holdings are meant to provide liquidity for an emergency, that objective must trump any desire to maximize the yield on those cash holdings. Too many investors failed to grasp this reality in the last cycle. They took on more risk in an effort to squeeze out a little more yield from short-term holdings and paid the price. As Seth Klarman of The Baupost Group pointed out in his latest investor letter: “Do not accept principal risk while investi ng short-term cash: the greedy effort to earn a few extra basis points of yield inevitably leads to the incurrence of greater risk, which increases the likelihood of losses and severe illiquidity at precisely the moment when cash is needed ...” Clear focus on the purpose for the cash (instant, safe liquidity) dictates an extremely low threshold for uncertainty—including new investment products created to sell on Wall Street.
If Not Now, When?
Although it is always a good time to begin thinking properly about your financial future, certain times tend to be better than others for taking action. For instance, paying off debt can be a great idea, but paying off that debt at stock market peaks yields a better result than paying it off at stock market troughs. The difference can impact your whole future. Thinking through the Margin of Safety concept has ramifications for many areas of your financial life. Now is the time to work through that with your Wealth Advisor. And, with financial markets dramatically higher than a year ago, now may be a good time to take any actions needed to build more Margin of Safety into your financial life.
