Value Investing

Seth Klarman: What Is An Appropriate Margin Of Safety Before Making An Investment

Margin of Safety, by Seth Klarman is one of the best books ever written on investing and a must read for all investors. One of the most important investing concepts discussed in the book is the ‘margin of safety’, popularized by Ben Graham. Seth Klarman describes the ‘margin of safety’ as follows:

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Seth Klarman

“The best investments have a considerable margin of safety. This is Benjamin Graham’s concept of buying at a sufficient discount that even bad luck or the vicissitudes of the business cycle won’t derail an investment. As when you build a bridge that can hold 30-ton trucks but only drive 10-ton trucks across it, you would never want your investment fortunes to be dependent on everything going perfectly, every assumption proving accurate, every break going your way.”

But what is an appropriate margin of safety before making an investment?

Klarman provides one answer in the following excerpt from the book:

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.

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Article by Johnny Hopkins, The Acquirer's Multiple