DCF Myth 3.1: The Margin of Safety – Tool for Action or Excuse for Inaction?
In my last post on dealing with uncertainty, I brought up the margin of safety, the tool that many value investors claim to use to protect themselves against uncertainty. While there are certainly some in the value investing community who have found a good way to incorporate MOS into their investing process, there are many more who seem to have misconceptions about what it does for them as well as the trade off from using it.
The Margin of Safety: Definition and Rationale
While the margin of safety has always been around, in one form or another, in investing, it was Ben Graham who brought the term into value investing in The Intelligent Investor, when he argued that the secret of sound investment is to have a margin of safety, with the margin of safety defined as the difference between the value of an asset and its price. The definitive book on MOS was written by Seth Klarman, a value investing icon. Klarman’s book has acquired a cult following, partly because of its content and partly because it has been out of print now for years; a quick check of Amazon indicates a second-hand copy can be acquired for about $1600. Klarman’s take on margin of safety is similar in spirit to Graham’s measure, with an asset-based focus on value, which is captured in his argument that investors gain the margin of safety by “buying at a significant discount to underlying business value and giving preference to tangible assets over intangibles”.
There are many reasons offered for maintaining a margin of safety. The first is that the value of an asset is always measured with error and investors, no matter how well versed they are in valuation techniques, have to recognize that they can be wrong in their judgments. The second is that the market price is determined by demand and supply and if it diverges from value, its pathway back is neither quick nor guaranteed. The proponents of margin of safety point to its benefits. By holding back on making investment decisions (buy or sell) until you feel that you have a margin of safety, they argue that you improve your odds of making successful investments. In addition, They also make the point that having a healthy margin of safety will reduce the potential downside on your investments and help protect and preserve your capital.
The Margin of Safety: Divergence across Investors
As a concept, I not only understand the logic of the MOS, but also its allure, and I am sure that many investors adopt some variant of it in active investing, but there are differences in how it is employed:
- Valuation Basis: While MOS is often defined it as the difference between value and price, the way in which investors estimate value varies widely. The first approach is intrinsic value, either in its dividend discount model format or a more expansive DCF version. The second approach estimates value from accounting balance sheets, using either unadjusted book value or variants thereof (tangible book value, for instance). The third approach is to use a pricing multiple (PE, EV to EBITDA), in conjunction with peer group pricing, toestimate “a fair price” for the company. While I would contest even calling this number a value, it is still used by many investors as their estimated value.
- Magnitude and Variability: Among investors who use MOS in investing, there seems to be no consensus on what constitutes a sufficient margin. Even among investors who are explicit about their MOS, the follow up question becomes whether it should be a constant (say 15% for all investments) or whether it should be greater for some investments (say in risky sectors or growth stocks) than for others (utilities or MLPs).
The bottom line is that a room full of investors who all claim to use margin of safety can contain a group with vast disagreements on how the MOS is computed, how large it should be and whether it should vary across investments and time.
Myths about Margin of Safety
When talking about value, I am often challenged by value investors on how I control for risk and asked why I don’t explicitly build in a MOS. Those are fair questions but I do think that some of the investors who are most enamored with the concept fundamentally misunderstand it. So, at the risk of provoking their wrath, here is my list of MOS misconceptions.
Myth 1: Having a MOS is costless
There are some investors who believe that their investment returns will always be improved by using a margin of safety on their investments and that using a larger margin of safety is costless. There are very few actions in investing that don’t create costs and benefits and MOS is not an exception. In fact, the best way to understand the trade off between costs and benefits is to think about type 1 and type 2 errors in statistical analysis. If type 1 errors refer to the fact that you have a false positive, type 2 errors reflect the opposite problem, where you have a false negative. Translating this proposition into investing, let’s categorize type 1 errors as buying an expensive stock, because you mistake it to be under valued, and type 2 errors as not buying a bargain-priced stock, because you perceive it wrongly to be over valued. Increasing your MOS will reduce your type 1 errors but will increase your type 2 errors.
Many risk averse value investors would accept this trade off but there is a cost to being too conservative and if that cost exceeds the benefits of being careful in your investment choice, it will show up as sub-par returns on your portfolio over extended periods. So, will using a MOS yield a positive or negative payoff? I cannot answer that question for you, because each investor has to make his or her own judgment on the question, but there are simple tests that you can run on your own portfolios that will lead you to the truth (though you may not want to see it). If you find yourself consistently holding more of your overall portfolio in cash than your natural risk aversion and liquidity needs would lead you to, and/or you don't generate enough returns on your portfolio to beat what you would have earned investing passively (in index funds, for instance), your investment process, no matter what its pedigree, is generating net costs for you. The problems may be in any of the three steps in the process: your valuations may be badly off, your judgment on market catalysts can be wrong or you may be using too large a MOS.
Myth 2: If you use a MOS, you can be sloppy in your valuations
Value investors who spend all of their time coming up with the right MOS and little on valuation are doing themselves a disservice. If your valuations are incomplete, badly done or biased, having a MOS on that value will provide little protection and can only hurt you in the investment process