Crossing the Bridge: What is Margin of Safety?

Crossing the Bridge: What is Margin of Safety?

The concept of “margin of safety” – which originates from Benjamin Graham’s earliest teachings – is a core tenet of value investing.

As Graham wrote in the very last chapter of The Intelligent Investor (Chapter 20:Margin of Safety” as the Central Concept of Investment):

Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.

The beauty of “margin of safety” lies in both the concept’s simplicity and in its effectiveness in protecting investors from making big mistakes.

Graham really was a pioneer in behavioral finance before behavioral finance was even a thing, and the margin of safety concept was one of the first tools that allowed investors to overcome their own biases, creating a protection against the “unknown unknowns” of an investment.

SO WHAT IS MARGIN OF SAFETY?

Margin of safety is a very easy concept to understand.

As Ben Graham points out, “all experienced investors recognize that the margin-of-safety concept is essential to the choice of sound bonds.”

For example, if you are investing in a bond, you would probably want to make sure that the company has historically generated enough cash flow to cover interest payments and other fixed charges 3-times, 4-times, or even 5-times over in any given year.

Graham continues:

This past ability to earn in excess of interest requirements constitutes the margin of safety that is counted on to protect the investor against loss or discomfiture in the event of some future decline in net income… The margin above charges may be stated in other ways – for example, in the percentage by which revenues or profits may decline before the balance after interest disappears – but the underlying idea remains the same.

This makes sense, right?

A bank wouldn’t loan loan you money if you could only just barely pay the interest every month. They’d want there to be some cushion in case something goes wrong in the future (you lose your job, you get sick, etc.)

Graham simply took this simple fixed income concept and applied it to all assets, including stocks.

According to Graham:

The function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future. If the margin is a large one, then it is enough to assume that future earnings will not fall far below those of the past in order for an investor to feel sufficiently protected against the vicissitudes of time.

And, of course:

What is Margin of Safety?  WARREN BUFFETT’S BRIDGE ANALOGY

WHAT IS MARGIN OF SAFETY

WHAT IS MARGIN OF SAFETY

Warren Buffett – Ben Graham’s most famous and most successful disciple – compares margin of safety to driving across a bridge:

You have to have the knowledge to enable you to make a very general estimate about the value of the underlying business. But you do not cut it close. That is what Ben Graham meant by having a margin of safety. You don’t try to 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.

I love this analogy, and Warren Buffett has used it multiple times:

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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…

WHAT IS MARGIN OF SAFETY ACCORDING TO SETH KLARMAN

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Legendary value investor and founder of the Baupost Group hedge fund Seth Klarman (seeBenjamin Graham: The Father of Value Investing and His Family) published an entire book devoted to the subject of margin of safety in 1991: Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor.

The book, by the way, is out of print but is currently selling on eBay and Amazon for over $1,000 (not including $5 shipping & handling, of course). Luckily, Klarman’s book can be found through various (nefarious?) sources online.

According to Klarman:

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.

And how does Klarman think intelligent value investors can make sure they have 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.)… Since investors cannot predict when values will rise or fall, valuation should always be performed conservatively, giving considerable weight to worst-case liquidation value as well as to other methods.

WHAT IS MARGIN OF SAFETY? THE FAULT, DEAR BRUTUS, IS NOT IN OUR STARS, BUT IN OURSELVES

WHAT IS MARGIN OF SAFETY

In the introduction to The Intelligent Investor, Ben Graham writes:

What then will we aim to accomplish in this book? Our main objective will be to guide the reader against the areas of possible substantial error and to develop policies with which he will be comfortable… For indeed, the investor’s chief problem – and even his worst enemy – is likely to be himself… “The fault, dear investor, is not in our stars – and not in our stocks – but in ourselves…”

The margin of safety – one of the core principles of value investing – accomplishes exactly that, protecting us both from ourselves and from whatever unforeseen events the “stars” above might throw at our investments in the unpredictable future.



About the Author

VintageValueinvesting
Ben Graham, the father of value investing, wasn’t born in this century. Nor was he born in the last century. Benjamin Graham – born Benjamin Grossbaum – was born in London, England in 1894. He published the value investing bible Security Analysis in 1934, which was followed by the value investing New Testament The Intelligent Investor in 1949. Warren Buffett, the value investing messiah and Graham’s most famous and successful disciple, was born in 1930 and attended Graham’s classes at Columbia in 1950-51. And the not-so-prodigal son Charlie Munger even has Warren beat by six years – he was born in 1924. I’m not trying to give a history lesson here, but I find these dates very interesting. Value investing is an old strategy. It’s been around for a long time, long before the Capital Asset Pricing Model, long before the Black-Scholes Model, long before CLO’s, long before the founders of today’s hottest high-tech IPOs were even born. And yet people have very short term memories. Once a bull market gets some legs in it, the quest to get “the most money as quickly as possible” causes prices to get bid up. Human nature kicks in and dollar signs start appearing in people’s eyes. New methodologies are touted and fundamental principles are left in the rear view mirror. “Today is always the dawning of a new age. Things are different than they were yesterday. The world is changing and we must adapt.” Yes, all very true statements but the new and “fool-proof” methods and strategies and overleveraging and excess risk-taking only work when the economic environmental conditions allow them to work. Using the latest “fool-proof” investment strategy is like running around a thunderstorm with a lightning rod in your hand: if you’re unharmed after a while then it might seem like you’ve developed a method to avoid getting struck by lightning – but sooner or later you will get hit. And yet value investors are for the most part immune to the thunder and lightning. This isn’t at all to say that value investors never lose money, go bust, or suffer during recessions. However, by sticking to fundamentals and avoiding excessive risk-taking (i.e. dumb decisions), the collective value investor class seems to have much fewer examples of the spectacular crash-and-burn cases that often are found with investors’ who employ different strategies. As a result, value investors have historically outperformed other types of investors over the long term. And there is plenty of empirical evidence to back this up. Check this and this and this and this out. In fact, since 1926 value stocks have outperformed growth stocks by an average of four percentage points annually, according to the authoritative index compiled by finance professors Eugene Fama of the University of Chicago and Kenneth French of Dartmouth College. So, the value investing philosophy has endured for over 80 years and is the most consistently successful strategy that can be applied. And while hot stocks, over-leveraged portfolios, and the newest complicated financial strategies will come and go, making many wishful investors rich very quick and poor even quicker, value investing will quietly continue to help its adherents fatten their wallets. It will always endure and will always remain classically in fashion. In other words, value investing is vintage. Which explains half of this website’s name. As for the value part? The intention of this site is to explain, discuss, ask, learn, teach, and debate those topics and questions that I’ve always been most interested in, and hopefully that you’re most curious about, too. This includes: What is value investing? Value investing strategies Stock picks Company reviews Basic financial concepts Investor profiles Investment ideas Current events Economics Behavioral finance And, ultimately, ways to become a better investor I want to note the importance of the way I use value here. It’s not the simplistic definition of “low P/E” stocks that some financial services lazily use to classify investors, which the word “value” has recently morphed into meaning. To me, value investing equates to the term “Intelligent Investing,” as described by Ben Graham. Intelligent investing involves analyzing a company’s fundamentals and can be characterized by an intense focus on a stock’s price, it’s intrinsic value, and the very important ratio between the two. This is value investing as the term was originally meant to be used decades ago, and is the only way it should be used today. So without much further ado, it’s my very good honor to meet you and you may call me…