Margin of Safety

According to Warren Buffett, the two rules of investing are:

• Rule No. 1: Never lose money
• Rule No. 2: Never forget Rule No. 1

As an individual investor who started investing just before the dot com bust, I have learned this the hard way but now these tenets are instilled in me.

Warren Buffett’s teacher and father of value investing, Ben Graham, first coined the "margin of safety" expression in his classic text, The Intelligent Investor. In investing, trends come and go all the time. However, these words have stood the test of time. Even today, Warren Buffett calls them "the three most important words in all of investing."

The beauty of value investing is in its simplicity. All one has to do is:

1. Calculate the intrinsic value of a company.
2. Buy the stock if it can purchased at a suitable margin of safety compared to its intrinsic value.
3. Wait for the market to correct the stock price.
   

[The intrinsic value of an investment is determined by discounting the future cash flows of an investment by an appropriate interest rate. I personally use DCF analysis.]

While this approach is painfully simple, it is difficult to follow. The main reason is that since every investor has to make assumptions to calculate this value, the estimates can vary widely. This is where margin of safety comes in. Ben Graham used a 33% (one-third) margin of safety compared to the book value when looking for potential investments. Other value investors have a different hurdle rate. The bottom line is: the wider the margin of safety, the better it is. To paraphrase Buffett, “You build a bridge that can withstand 30,000 ton trucks but insist that only 10,000 ton trucks drive on it”.

The more I thought about this, the more it made sense. As an engineer designing complex technical solutions, I was using margin of safety everyday. When working on industrial applications, I would scale up the pilot test data to design production scale systems incorporating a safety factor or scale-up factor: this is exactly the concept of margin of safety!

Margin of safety protects us from the whims of the market and minimizes the risk of permanent loss of capital. There are two main benefits:

1. Lets say you made an investment in a company that was selling at a 40% margin of safety. Suppose there is a change in the company’s business or if your assumptions were not as accurate, and the new margin of safety is 20%. You are still protected and can wait for your thesis to play out.
2. The other advantage is the higher upside potential. Suppose your original thesis was sound and you were able to purchase the company at a 40% discount. Just because the market restores the company price to match its intrinsic value, your investment will have a 66% return!

Of course, having a disciplined strategy is easier said than done. Even if you apply a margin of safety in your purchase decision, any subsequent decrease in price may be difficult on your system. This is where your temperament comes in. Ideally, any change in price should be considered as an opportunity to buy, sell or hold that investment. In other words, look at it as if you were approaching it for the first time.

In the end, it takes discipline to apply the margin of safety and courage to stick with your investments when the gusts are blowing in your face.