In life, whatever we do, we do for our benefit,
in business to get the profit, in investing to get the profit. And to get the
benefit we will take the risk but how much risk we should take that is the real
question? How to make the odds in our favor, so we will get benefit or minimum
loss?
To get the answer of these questions, we have
one concept called "Margin of safety" in investing.
Let’s explore the Margin of Safety(MoS)
As per the definition from Wikipedia:
"Margin of
safety (safety margin) is the difference between the intrinsic value of a
stock and its market price. Another definition: In Break-even analysis
(accounting),margin of safety is how much output or sales level can fall
before a business reaches its breakeven point."
In words of Charlie Munger the MoS is :
“We try to arrange
[our affairs] so that no matter what happens, we'll never have to 'go back to
go.”
In simple words, the Margin of safety means you
are going to buy something that cost 100rs in 60rs or 70rs. in life, while
taking any decision that is risky(Like borrowing money on higher interest rates),
you will evaluate the decision and risk properly and try to identify the odds
of getting wrong and benefits of getting right and then compare both, if the
odds of getting wrong is more harmful then the benefits of getting right then
you will skip that risk and risky decision.
Albert Einstein said:
“Whoever undertakes to
set himself up as a judge of truth and knowledge is shipwrecked by the laughter
of the gods.”
We can't predict what is going to happen in
life. Never underestimate the chance of rare events. To protect us from all the
unknowns that lie ahead we can either avoid certain situations, make decisions
that work out for a wide range of outcomes, have backups or a huge margin of
safety. For example, when investing money the following can guide us: know the
underlying business value, don't use leverage, enter situations where the
management is able and honest, and invest with a huge margin of safety.
In the book Seeking
wisdom from Darwin to Munger by Peter Bevelin, Peter explained the
Margin of safety. The author asked many questions as below and get them answered
from the world renowned leaders like Warren Buffet, Charlie munger.
How much margin of safety do we need? Warren
Buffett answers:
“If you understand a
business - if you can see its future perfectly - then, obviously, you need very
little in the way of margin of safety. Conversely, the more things that can
happen, the more uncertainty there is, the more vulnerable the business is or
the greater the possibility of change, the larger margin of safety you require...
If you're driving a
9,800 pound truck across a bridge that says it holds 10,000 pounds and the
bridge is only about six inches above the ground, then you may feel 0 K.
However, if the bridge is over the Grand Canyon, then you may want a little
larger margin of safety. And, therefore, you may only drive a 4,000 pound truck
across. So it depends on the nature of the underlying risk.”
What else is important?
“We have a better
chance of avoiding misjudgment and improving our lives if we have the right
attitude and follow certain values.”
In writer Janet Lowe's wonderful biography of
Charles Munger, Damn Right!, we can learn some of Charles
Munger's views on values and behavior from his stepson, Hal Borthwick:
Charlie drummed in the
notion that a person should always “Do
the best that you can do. Never tell a lie. If you say you're going to do it,
get it done. Nobody gives a shit about an excuse. Leave for the meeting early.
Don't be late, but if you are late, don't bother giving people excuses. Just
apologize ... Return your calls quickly. The other thing is the five second no.
You've got to make your mind up. You don't leave people hanging.”
From the blog Seeking
Wisdom by Jana, he explained the MoS with some examples from
Casino, insurance, NBFCs in a very beautiful manner, you must read it. I am
borrowing the below excerpt from Jana's blog:
In the speech Super investors of
Graham-and-Doddsvile given by Warren Buffett in 1984,
commemorating the 50th anniversary of Security Analysis, he defines Margin of
Safety as ‘Buying 1 dollar for 50 cents.
Excerpt from the speech.
“You also have to have
the knowledge to enable you to make a very general estimate about the value of
the underlying businesses. But you do not cut it close. That is what Ben Graham
meant by having a margin of safety. You don’t try and buy businesses worth $83
million for $80 million. You leave yourself an enormous margin. 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.”
Jana explained why we need MoS as below:
We need Margin of Safety to protect us
1. From our mistakes and biases.
2. From unexpected market downturns like what happened in 2000 and
2008.
3. To have a peaceful sleep.
Seth Klarman has written a book on “Margin
of Safety”, in which he writes:
Necessary Arrogance
“At the root of value investing is the belief, first espoused by
Benjamin Graham, that the market is a voting machine and not a weighing
machine. Thus an investor must have more confidence in his or her own opinion
than in the combined weight of all other opinions. These borders on arrogance,
the necessary arrogance that is required to make investment decisions. This
arrogance must be tempered with extreme caution, giving due respect to the
opinions of others, many of whom are very intelligent and hard working. Their
sale of shares to you at a seeming bargain price may be the result of
ignorance, emotion or various institutional constraints, or it may be that the
apparent bargain is in fact flawed, that it is actually fairly priced or even
overvalued and that sellers know more than you do. This is a serious risk, but
one that can be mitigated first by extensive fundamental analysis
and second by knowing not only that something is bargain-priced but, as
best you can, also whyit is so. You never know for certain why sellers are
getting out but you may be able to reasonably surmise a rationale.”
In Bridge building, everybody understands that
if you’re building a bridge, you don’t want a bridge that will handle exactly
the maximum likely load and no more. You want a bridge that will handle a lot
more than the maximum likely load. And that margin of safety is just enormously
important in bridge-building.
In the book, “Security Analysis” Benjamin Graham wrote:
“There are instances where an
equity share may be considered sound because it enjoys a margin of safety as
large as that of a good bond. This will occur, for example, when a company has
outstanding only equity shares that under depression conditions are selling for
less than the amount of the bonds that could safely be issued against its property
and earning power. In such instances the investor can obtain the margin of
safety associated with a bond, plus all the chances of larger income and
principal appreciation inherent in an equity share.”
From the book, The
Intelligent Investor, one full chapter is
devoted to MoS in investment in stock market, as per the book:
“There are instances where an
equity share may be considered sound because it enjoys a margin of safety as
large as that of a good bond. This will occur, for example, when a company has
outstanding only equity shares that under depression conditions are selling for
less than the amount of the bonds that could safely be issued against its
property and earning power. In such instances the investor can obtain the
margin of safety associated with a bond, plus all the chances of larger income
and principal appreciation inherent in an equity share.”
I will close the post with the wonderful words
from Warren Buffet:
“We insist on a margin of safety in our purchase price. If we
calculate the value of a common stock to be only slightly higher than its
price, we’re not interested in buying. We believe this margin-of-safety
principle, so strongly emphasized by Ben Graham, to be the cornerstone of
investment success.”
You can read my other post on the below topic by clicking on the link:
- Thought on Contrast comparison
- Thought on Envy and jealousy
- Thought on Wrong decision making
Keep reading and keep learning.
Mahesh
