Sunday, July 29, 2007

The Three Most UnderValued Words in Investing: MARGIN OF SAFETY

Margin of Safety.

These words were officially brought to light in The Intelligent Investor by Ben Graham. And when you mention them to most money managers, they nod in approval and understanding. Yet, statistical performance results tell you another story. When 8 out of 10 mutual funds fail to be the benchmark, it means fund managers are simply over paying for businesses.

Only three types of investments exist -

1. under priced,
2. fairly priced, and
3. overpriced.

Value investors, by nature, engage in only three activities:

1. Buy the under priced assets
2. Hold or sell the fairly priced assets.
3. Avoid the over priced assets.

Yet finding under priced assets is not easy nor should it be. Further, an asset's intrinsic value is not an exact number but instead a value determined by several analytical inputs based on data and reasoning. Having a satisfactory margin of safety protects the intelligent investor from engaging in folly that results in a permanent loss of capital.

Ben Graham succinctly put it when he said,

"An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative."

Whether or not money managers realize it, most "investments" are more often just mere speculative activities hinging upon the actions of management and the future results of the business. Of course in a bull market, speculation is mistaken for investing. Bull markets tend to disguise everyone as an investing genius. But we all know that a value investor is more focused on making it through bear market storms relatively unscathed.

Buffett said it best in his letter to his limited partners in 1961:

"I would consider a year in which we decline 15% and the [Dow Jones] average 30% to be much superior to a year when both we and the average advanced 20%."

Most investors don't fully grasp this investing approach, and the result is inferior long-term performance relative to the benchmarks. Value investors always demand a margin of safety. And a margin of safety can come in various forms, but its sole purpose is to diminish the probability of a permanent loss of capital. Most important, the margin of safety insulates the enterprising investor from the inevitable surprises that Mr. Market may have up his sleeve.

Finally, remember that the intrinsic value of a business changes over time, and therefore, so will the margin of safety. A 50% margin of safety one year may erode or widen the following year. If your assessment of intrinsic value changes, then so must your investment decision - to either buy more of a now more under priced assets with a greater margin of safety, or dispose of a 50 cent dollar that has now become a 90 cent dollar. Either way, all roads lead to one path in which you come out with minimal loss of capital.

Price is what you pay, value is what you get.

For more on margin of safety, check out my write up on at the Motley Fool:


College Knowledge said...

Great post and great link to the article at The Fool! Keep it up, these sort of posts are valuable. -Rafael

Dreama said...

Keep up the good work.