Thinking About Margin Of Safety

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Thinking About Margin Of Safety
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If anything, the past few years has reminded us that the future is unknown and events can take turns you would never expect. Businesses have set-backs, economies have downturns and even the best investors make mistakes. Because of this, leaving some room for error makes eminent sense. Almost a century ago, Ben Graham first proposed the concept of Margin of Safety in his seminal book, ‘Security Analysis.’ Ever since, the term has been indoctrinated into the investing lexicon of the world’s most successful investors.

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Like most things investing however, there’s conjecture around what constitutes a ‘Margin of Safety.’ While most investors consider margin of safety in the context of a purchase discount relative to a company’s intrinsic value, others look towards low valuation ratios, avoiding high multiple stocks, seeking a high degree of business quality or a combination thereof.

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If you subscribe to Buffett’s first rule of investing, ‘Don’t Lose Money,’ then, ‘Don’t buy without a Margin of Safety,’ would seem sensible advice. But how do you achieve it? Should a ‘Margin of Safety’ be applied to all investments? Or to the portfolio as whole? Is it acceptable to invest without a margin of safety?

Over the years, my views on Margin of Safety have evolved. Here are some thoughts.

Low Ratios

A common misconception is that low stock valuation multiples provide a margin of safety. This line of reasoning assumes bad news is already priced in, rendering share prices indifferent to negative developments.

Over two decades of experience in markets would have me believe otherwise. A stock purchased on a low multiple doesn’t imply a margin of safety. Screening for low multiple stocks is just as likely to get you caught in ‘value traps’; businesses whose best times are behind them.

"If anything, we are less likely to look at something that sells at a low relationship to book than something that sells at a high relationship to book, because the chances are we’re looking at a poor business in the first case and a good business in the second case.” Warren Buffett

“Starting with a rank-order valuation screen is more likely to lead you into less than-optimal businesses.” Brian Bares

When you own an inferior business, time is working against you - as the underlying value of the business deteriorates.

“The investor who spots a price discrepancy in an ordinary business hopes that the share price will promptly rise to the intrinsic value he has estimated. The more time passes, the longer they take to realise the forecast return, and the more exposed they are to uncontrollable risks.” IP Capital

If buying low PE stocks were the key to investment success, we’d all be rich. In recent times, limiting yourself to such stocks has meant forgoing many of the best investment opportunities. If you moved to a new city, would you ask the local agent for the names of the cheapest suburbs? Not likely. The same should apply to investing.

High Ratios

All things being equal, the lower the multiple paid for a business, the better; you’re paying less for the business and there’s less room for the multiple to fall should things not pan out as expected. It doesn’t follow however, that purchasing a stock on a high multiple provides no margin of safety. The first question to ask is, ‘is today’s multiple even relevant?’ and the follow up questions are, ‘what will the earnings be in three to five years time?’ and, ‘what will the multiple be in three to five years time?”

Some of the best investment opportunities arise when investors and analysts apply standard industry multiples to near term earnings which are completely anomalous to where a business might be in the future (completely undervaluing the company). In such cases, the near term multiple can be meaningless. Joel Greenblatt made this point in a recent interview:

“One of the big mistakes I made was looking at Walmart, seeing what a good business it was thirty years ago. Think about it this way, if you’re looking at the numbers to do with fifty stores but you can see they can have a thousand or two thousand stores, like any of these new internet businesses with an unlimited growth trajectory, the numbers you’re using at fifty stores aren’t very helpful. You might have a model that can expand, but putting a multiple on whatever you’re earning on fifty stores, if you could have 1000 or 2000, of course they’re meaningless. You really have to make some estimates about what the opportunity set is and what the competition will be over a long period of time. Traditionally these have been some of my biggest mistakes of omission. Missing huge opportunities.”

Stocks that look optically expensive today can actually be cheap on the basis of future earnings. Rather than disregard multiples altogether, it’s worth trying to establish whether the stock might be on a reasonable multiple in the future.

“In 2007, Apple traded at 30x EPS but only 3x 5 years out. The art of growth investing is realising a stock that appears expensive today can be dirt cheap 5-7 years later. Multi-baggers are the source of most outperformance and hide many mistakes.” Philipe Laffonte

"It isn’t a multiple of today’s earnings that is the primary determinate of things. We bought our Coca-Cola at a price of $11 a share. And it’ll earn $2.30-$2.40 this year. So, that’s under five times this year’s earnings, but it was a pretty good size multiple back when we bought it." Warren Buffett

Even businesses that don’t report profits can provide a Margin of Safety - it all comes down to understanding the specifics of the business; how is value defined? how it is created? what are the potential outcomes?

Bill Miller made this point at the 2019 Santa Fe Institute Symposium using Amazon and John Malone’s TCI as examples:

“Probably the best example of a misunderstanding of the valuation of anything has been Amazon over its entire history. It was constantly, you know, Baron’s saying, ‘Amazon.bomb,’ and everybody talking about how they don't make any money, they don't make any money, they don't make any money. CBC did a special on it, and one of the things they interviewed me about was Amazon's finances. They start off with, oh, how can you own this thing that doesn't make any money? And I have two answers to that.

Number one, John Malone, the great cable investor. I said, if you put one dollar in John's TCI when John became the CEO, and you kept it there for the twenty-five years that one dollar is 900 dollars. And he never reported a profit in twenty-five years. So, something else is going on besides profits and the report of profits.

With Amazon, I said, look, there’s a reason that they’re called ‘generally accepted accounting principles,’ and not ‘divinely inspired accounting principles’ or ‘immaculately conceived accounting principles.’ They’re a way to capture a certain type of information for particular kinds of companies that have a particular kind of economics.”

The confidence to underwrite the future requires an understanding of the primary drivers that will help ensure a business reaches the anticipated destination.

Due to the power of compounding, businesses that can sustain success over decades are often undervalued in spite of an ‘optically-high’ PE ratio. With regards to Walmart, Nick Sleep noted you could have paid 150 times the price in the early years and still earned a ten percent annual return. That’s 150 times the prevailing share price not 150 times earnings! Furthermore, ten years later you could have paid a 150X PE and earned ten percent returns. That really is the magic of compounding.

The world’s best investors often confess that selling great businesses because of a high near term multiple has been one of their biggest mistakes. If the destination is intact, stay the course.

Discount To Intrinsic Value

Generally, the most accepted definition of Margin of Safety relates to a company’s Intrinsic Value; the present value of a business’ future cashflows. Purchasing at a discount to one’s estimate of Intrinsic Value provides the Margin of Safety. While highly subjective, the more predictable a company’s earnings over the long term, the less divergent the estimates of intrinsic value will be, and the more reliable the calculation of a margin of safety.

"The concept of a margin of safety is that an investor should purchase a security at a price sufficiently below his estimate of its intrinsic value that he will have protection against permanent loss even if his estimate proves somewhat optimistic.” Ed Wachenheim

"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, emphasised by Ben Graham, to be the cornerstone of investment success." Warren Buffett

The idea of buying at a discount to intrinsic value is never going to become obsolete. Provided you’ve got the ability to ride out any short term volatility, in time, you’ll be rewarded as the share price converges with intrinsic value.

Quality

Quality’ is another investing term that’s hard to define; a conservative balance sheet, aligned management, high returns on capital and a track record of success make a good foundation. As regards the future, it’s often the qualitative characteristics that determine performance; a business’ purpose, management, culture, adaptability, innovativeness and the company’s relationships within its ecosystem.

Margin of Safety is about ensuring survival, both now and in the future. History has shown high-quality companies tend to weather near-term volatility, crises, corporate mishaps and competitive threats better than lower quality businesses - and go on to prosper in time.

“Major capital losses occur mostly when the business suffers irreparable damage. Exceptional companies are, by definition, those best protected against competitors, disruptive technologies, poor governance, and other factors that can destroy value. A portfolio of exceptional companies can be both more concentrated and safer than a portfolio of ordinary companies.” IP Capital

“Bad companies are destroyed by crises; good companies survive them; great companies are improved by them.” Andy Grove, Intel

The best businesses do things differently, they tend to be the leaders in what they do, they thrive in different environments, they fulfil an important customer demand, they take a longer term view and do things right by their customers, employees, suppliers, community and shareholders. They develop new products, grow markets and have a level of control over their destiny. Investors who own them enjoy a Margin of Safety.

“The most important three words in investing, stated by Mr. Graham are: Margin of Safety. What that means to us, is that we are looking at investing in very, very high-quality companies that have great franchises and that have had these great franchises for many years.” David Polen

“The best long term margin of safety comes not from an investment’s price but from the value of a company’s sustained competitive advantage over very long periods of time. That’s what quality investing is all about.” Thomas Russo

“[Ben Graham] gave the world the concept of margin of safety. We utilise that very much and the margin of safety for us is the quality of each business that we are investing in." Jeff Mueller

“The margin of safety is not just in the price you pay, it's also in the quality of the business, it's in the balance sheet of the business and the accounting and also in terms of the quality of top management. When we bought shares of Constellation Software, I don't remember how much we paid but we paid a reasonable valuation, I think 18 or 19 times earnings. To us the real margin of safety was Mark Leonard.” Francois Rochon

“When people talk about margin of safety in investing, they usually talk about things that are financial in nature. They talk about asset value or they talk about sustainable return on equity or whatever. I'm much more focused on the nature of business franchise and the replicability of that, and the quality of the people running it.” Steve Mandel

"A good business model provides the ultimate margin of safety." Jake Rosser

Exceptional businesses compound their capital at high rates over time while inferior businesses tend to compound their disadvantages. Compounding machines are defined by high quality businesses, not cheap price.

Portfolio Margin of Safety

Where I once looked for a margin of safety in every investment, I now consider Margin of Safety in a portfolio context which allows me to relax the requirements for a small portion of the portfolio. I’m an advocate of the idea that markets are complex adaptive systems; they’re unpredictable, the whole is greater than the sum of the parts, and they’re subject to non-linear outcomes. Capturing some of that non-linearity may require you to venture into companies with less margin of safety; perhaps the business is yet to hit an inflection point, hasn’t been stress tested by economic cycles, offers a somewhat binomial outcome or the balance sheet isn’t as pristine as one would ordinarily prefer.

An investment with the potential to be a multi-bagger might be worth considering in a portfolio context despite a limited ‘Margin of Safety.’

“I confess to finding the Margin of Potential Upside more alluring than the classic Margin of Safety.” James Anderson

“If you can lose 100 percent on something, so say an option, that doesn’t mean you shouldn’t ever buy options. Sometimes they’re really interesting and if you can sometimes get to the point of view that even though you can lose 100 percent on a particular investment, it might be an interesting thing to do.” David Abrams

“I will invest in companies where the possibility the equity goes to zero has to be recognised as part of the equation – and my record on that front is not spotless. Charlie Munger has talked about how depending on the probabilities you assign to the up and down case, it may be a perfectly reasonable bet to accept the possibility of a zero if your upside is 5x or more. I agree.” Robert Robotti

Even Messrs Buffett and Munger have recognised as much. Given the nature of their insurance business, this may come as little surprise.

“Charlie and I by nature are pretty risk-averse. But we are very willing to enter into transactions — if we knew it was an honest coin, and someone wanted to give us seven-to-five or something of the sort on one flip, how much of Berkshire’s net worth would we put on that flip? Well it would sound like a big number to you. It would not be a huge percentage of the net worth, but it would be a significant.” Warren Buffett

"Mostly, Berkshire, in its history, has bought common stocks that practically couldn’t fail. But occasionally, Berkshire just makes an intelligent gamble where there’s plenty of chance of failure, but there’s enough chance of success so the gamble is worth taking." Charlie Munger

A portfolio can provide a Margin of Safety despite a small component having elevated downside risk. An everyday example is index investing. The S&P500 has managed to compound at c.10%pa for the last hundred years in spite of many component companies losing significant value or becoming bankrupt.

Buffett has long analogised investing to baseball, but better. There are no strike-outs. Taking that analogy a step further, it’s been noted .. ‘‘Baseball has a truncated outcome distribution. When you swing, no matter how well you connect with the ball, the most runs you get is four. In the wider world, every once in a while, when you step up to the plate, you can score 1,000 runs.” That’s certainly true of investing. Baillie Gifford’s James Anderson points to research by Professor Hendrik Bessembinder showing the entire gain in the US stock market since 1926 can be attributable to the best-performing four percent of listed companies (when stated in terms of lifetime dollar wealth creation).

One of the most insightful investment papers I’ve ever read is Charlie Munger’s 1996 discussion of Coca-Cola. Here, Munger presents a case study that asks rhetorically how one would go about producing a $2 trillion business from an initial $2m outlay - the focus is very much on the upside rather than the downside. The story encapsulates the incredible asymmetric opportunities that can exist in markets.

Searching for these outliers and sizing such positions appropriately can enhance portfolio performance while not exposing the portfolio to an undue level of risk.

'To have a few higher-multiple names is very different than having a weighted average price/sales ratio of 6x or even higher at the whole portfolio level. The air begins to get thin at those altitudes!' Rajiv Jain

Dual Margin of Safety

Many of the world’s most successful investors have adopted the concept of a ‘dual’ margin of safety - seeking high quality companies at attractive discounts to intrinsic value.

“We strive to avoid situations without our cherished dual margin of safety – the quality of business and the price. We need both to counter our inevitable mistakes and unforeseen events.” Christopher Bloomstran

“Margin of safety for us comes from the quality of the business and second from buying into it at a substantial discount to our estimate of intrinsic value. Neither is sufficient on its own for us to be interested.” Mark Curnin

"The margin of safety in our investment strategy is to identify fundamentally good businesses and adhere to strict valuation discipline." Jeffrey Ubben

Summary

While a Margin of Safety doesn’t pertain to purchasing low multiple stocks or avoiding high multiple stocks, it can be attained, over the longer term, by holding high quality businesses acquired below their intrinsic value.

Unfortunately, little in investing is clear cut and there are plenty of exceptions to the received dogma. Even investments with a low margin of safety can enhance portfolio results if they offer the prospect of highly asymmetric returns, provided the overall portfolio exhibits an appropriate margin of safety.

Participating in such highly skewed opportunities might require an evolution in thinking beyond the traditional mantra of value investing; applying the concept of margin of safety to the portfolio as a whole, while relaxing that constraint at the individual stock level.

A portfolio comprised primarily of companies exhibiting a dual margin of safety combined with some asymmetric opportunities, appropriately sized, might provide the best of all worlds.

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