Mental Model: Margin of Safety

TIIOldThe Secret of Sound Investment

“In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, “This too will pass.” Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY. This is the thread that runs through all the preceding discussion of investment policy—often explicitly, sometimes in a less direct fashion. Let us try now, briefly, to trace that idea in a connected argument.”  Benjamin Graham, Chapter 8: “Margin of Safety” as the Central Concept of Investment, Intelligent Investor, Revised Edition

Engineering and the Factor of Safety

“Factor of safety (FoS), also known as (and used interchangeably with) safety factor (SF), is a term describing the structural capacity of a system beyond the expected loads or actual loads. Essentially, how much stronger the system is than it usually needs to be for an intended load. Safety factors are often calculated using detailed analysis because comprehensive testing is impractical on many projects, such as bridges and buildings, but the structure’s ability to carry load must be determined to a reasonable accuracy.

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Definition

There are two distinct definitions for the factor of safety: One as a ratio of absolute strength (structural capacity) to actual applied load, this is a measure of the reliability of a particular design. The other use of FoS is a constant value imposed by law, standard,specification, contract or custom to which a structure must conform or exceed.

The first use (a calculated value) is generally referred to as a factor of safety or, to be explicit, a realized factor of safety. The second use (a required value) as a design factor, design factor of safety or required factor of safety. However, between various industries and engineering groups usage is inconsistent and confusing, it is important to be aware of which definition(s) are being used. The cause of much confusion is that various reference books and standards agencies use the factor of safety definitions and terms differently. Design codes and structural and mechanical engineering textbooks often use “Factor of Safety” to mean the fraction of total structural capability over that needed (first use). Many undergraduate Strength of Materials books use “Factor of Safety” as a constant value intended as a minimum target for design (second use).” Source: Wikipedia

Margin of Safety in Investing

“If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. So, the more vulnerable the business is, assuming you still want to invest in it, the larger margin of safety you’d need. If you’re driving a truck across a bridge that says it holds 10,000 pounds and you’ve got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay, but if it’s over the Grand Canyon, you may feel you want a little larger margin of safety…”  1997 Berkshire Hathaway Annual Meeting, quoted in Andrew Kilpatrick, Of Permanent Value: The Story of Warren Buffett

“Value investing, today as in the era of Graham and Dodd, is the practice of purchasing securities or assets for less than they are worth—the proverbial dollar for 50 cents. 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. While some might mistakenly consider value investing a mechanical tool for identifying bargains, it is actually a comprehensive investment philosophy that emphasizes the need to perform in-depth fundamental analysis, pursue long-term investment results, limit risk, and resist crowd psychology.”  Seth Klarman, foreword, Security Analysis, 6th Edition

margin_of_safety

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Seth Klarman’s Margin of Safety

Seth Klarman wrote in his well-known book Margin of Safety that “Value investors, by contrast, have as a primary goal the preservation of their capital. It follows that value investors seek a margin of safety, allowing room for imprecision, bad luck, or analytical error in order to avoid sizable losses over time. A margin of safety is necessary because valuation is an imprecise art, the future is unpredictable, and investors are human and do make mistakes. It is adherence to the concept of a margin of safety that best distinguishes value investors from all others, who are not as concerned about loss.”

Also, Klarman wrote that “The most beneficial time to be a value investor is when the market is falling. This is when downside risk matters and when investors who worried only about what could go right suffer the consequences of undue optimism. Value investors invest with a margin of safety that protects them from large losses in declining markets.”

MOS2

Below is an excerpt from chapter six, Value Investing: Importance of a Margin of Safety, of the book Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor written by Seth Klarman.

“The Importance of a Margin of Safety

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.

Because investing is as much an art as a science, investors need a margin of safety. A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable, and rapidly changing world. According to Graham, “The margin of safety is always dependent on the price paid. For any security, it will be large at one price, small at some higher price, nonexistent at some still higher price.

Buffett described the margin of safety concept in terms of tolerances: “When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And that same principle works in investing.”

What is the requisite margin of safety for an investor? The answer can vary from one investor to the next. How much bad luck are you willing and able to tolerate? How much volatility in business values can you absorb? What is your tolerance for error? It comes down to how much you can afford to lose.

Most investors do not seek a margin of safety in their holdings. Institutional investors who buy stocks as pieces of paper to be traded and who remain fully invested at all times fail to achieve a margin of safety. Greedy individual investors who follow market trends and fads are in the same boat. The only margin investors who purchase Wall Street underwritings or financial-market innovations usually experience is a margin of peril.

Even among value investors there is ongoing disagreement concerning the appropriate margin of safety. Some highly successful investors, including Buffett, have come increasingly to recognize the value of intangible assets-broadcast licenses or soft-drink formulas, for example-which have a history of growing in value without any investment being required to maintain them. Virtually all cash flow generated is free cash flow.

The problem with intangible assets, I believe, is that they hold little or no margin of safety. The most valuable assets of Dr Pepper/Seven-Up, Inc., by way of example, are the formulas that give those soft drinks their distinctive flavors. It is these intangible assets that cause Dr Pepper/Seven-Up, Inc., to be valued at a high multiple of tangible book value. If something goes wrong-tastes change or a competitor makes inroads-the margin of safety is quite low.

Tangible assets, by contrast, are more precisely valued and therefore provide investors with greater protection from loss. Tangible assets usually have value in alternate uses, thereby providing a margin of safety. If a chain of retail stores becomes unprofitable, for example, the inventories can be liquidated, receivables collected, leases transferred, and real estate sold. If consumers lose their taste for Dr Pepper, by contrast, tangible assets will not meaningfully cushion investors’ losses.

How can investors be certain of achieving a margin of safety? By always buying at a significant discount to underlying business value and giving preference to tangible assets over intangibles. (This does not mean that there are not excellent investment opportunities in businesses with valuable intangible assets.) By replacing current holdings as better bargains come along. By selling when the market price of any investment comes to reflect its underlying value and by holding cash, if necessary, until other attractive investments become available.

Investors should pay attention not only to whether but also to why current holdings are undervalued. It is critical to know why you have made an investment and to sell when the reason for owning it no longer applies. Look for investments with catalysts that may assist directly in the realization of underlying value. Give preference to companies having good managements with a personal financial stake in the business. Finally, diversify your holdings and hedge when it is financially attractive to do so. Each of these points is discussed in the chapters comprising the remainder of this book.

To appreciate the margin of safety concept, consider the stock of Erie Lackawanna, Inc., in late 1987, when it was backed by nearly $140 per share in cash as well as a sizable and well-supported tax refund claim against the IRS. The stock sold at prices as low as $110 per share, a discount from the net cash per share even exclusive of the refund claim. The downside risk appeared to be zero. The only foreseeable loss on the stock would be a temporary market-price decline, a development that would merely render the shares a still better buy. Ultimately Erie Lackawanna won its tax case. Through mid-1991 cumulative liquidating distributions of $179 per share had been paid ($115 was paid in 1988, returning all of a buyer’s late 1987 cost), and the stock still traded at approximately $8 per share.

Similarly Public Service Company of New Hampshire (PSNH) 18 percent second-mortgage bonds traded in early 1989 at about par value. Although formally in bankruptcy PSNH had continued to pay current interest on these bonds because their principal amount was covered many times over by the value of the utility assets securing them. The contractual maturity date of these bonds was June 1989, but investors were uncertain whether or not they would be retired if the company were then still in Chapter 11. Other than the possibility of a near-doubling of interest rates, there was immaterial downside risk other than from short-term price fluctuations. PSNH ultimately raised money to retire the bonds in November 1989, several months after their contractual maturity date. Investors were able to earn annualized returns of 18 percent with very low risk due to the uncertain timing of the bonds’ redemption.

Perhaps the best recent example of investing with a margin of safety occurred in the debt securities of Texaco, Inc. In 1987 Texaco filed for bankruptcy as a result of uncertainty surrounding a $10 billion legal verdict against it in favor of Pennzoil.

Although the value of Texaco’s assets appeared to more than fully cover all of its liabilities even under a worst-case scenario, in the immediate aftermath of Texaco’s Chapter 11 filing its stock and bonds plunged in price. As with any bankruptcy, many investors were suddenly constrained from owning Texaco securities. Even the company’s public statement that bondholders would receive all principal and postpetition as well as prepetition interest failed to boost prices much.

The specific opportunity in Texaco securities was exemplified by the Texaco 11.875 percent debentures due May 1, 1994. These bonds traded actively at the 90 level (they traded flat; the price incorporated approximately eighteen months of accrued interest) in the wake of the October 1987 stock market crash. Assuming the full payment of principal and interest uponemergence from Chapter 11, these bonds purchased at 9 0 would provide annualized returns of 44.1 percent, 25.4 percent, and 19.5 percent, respectively, assuming a one-year, two-year, and three-year holding period from November 1, 1987. Could these bonds have declined further in price? Certainly, but they would simply have become a better buy. Uncertainty regarding the timing and exact resolution of the bankruptcy created an outstanding opportunity for value investors who were content with doing well under any scenario while always having a considerable margin of safety.”

Seth Klarman concludes chapter six by stating that “Value investing is simple to understand but difficult to implement. Value investors are not supersophisticated analytical wizards who create and apply intricate computer models to find pline to avoid the many unattractive pitches that are thrown, patience to wait for the right pitch, and judgment to know when it is time to swing. attractive opportunities or assess underlying value. The hard part is discipline, patience, and judgment. Investors need discipline to avoid the many unattractive pitches that are thrown, patience to wait for the right pitch, and judgment to know when it is time to swing.”

Further Reading

For a great summary of the mental model margin of safety, head over to the superb blog Farnam Street and the post Mental Model: Margin of Safety for further reading.

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