Investing with a Margin Safety

“Value investing, the strategy of investing in securities trading at

an appreciable discount from underlying value, has a long history

of delivering excellent investment results with very limited

downside risk”

~Seth Klarman

You would think that Warren Buffett’s favorite 2 chapters of any book of all time would be pretty useful? You would be right in thinking so, the two concepts explained in these chapters are the framework of Buffett’s investing methodology and are a huge part of his incredibly successful career. The two chapters are 8 and 20 of the revised edition of the Intelligent Investor, by Benjamin Graham. I will begin by explaining chapter 20, which deals with investing only when a large margin of safety.

My investing philosophy is based primarily on investing in common stocks with a significant discount to their intrinsic value.This concept originated with Benjamin Graham, the father of value investing. It has been followed by some of the most famous investors of all time, including Warren Buffett, Graham’s most famous and successful student, and many others such as Seth Klarman, Bill Ruane, and Charlie Munger. Investing with a margin of safety involves evaluating the intrinsic value of a company, comparing the current market price to the calculated intrinsic value, and only investing when there is a substantial discrepancy.

As an example, imagine I value General Electric’s shares to be worth $30/share, and they are trading for $10/share, I would be investing in each share with a margin of safety of essentially $20/share. The reason for investing with such a substantial margin of safety is because investing is an imperfect art. There is no way to perfectly forecast the future earnings of corporations; there is, however, the ability to approximate earnings and estimate a value for a company. Since we are prone to error, the margin between the current market price and our purchase price provides the safety for our investment. To return to the GE example, if I am off on my estimation of GE’s value by $14/share, and they are actually only worth $16/share, I am still purchasing GE’s shares at $.625 per dollar ($10/$16). Consequently, the larger the margin of safety that exist, the safer the investment opportunity is for the investor.

The corollary to this is that the investment has a greater prospect for a high rate of return because it has farther to return to its intrinsic value. So if GE shares are priced at $10/share and the intrinsic value is $30/share, it will have to increase 200% to return to its intrinsic value. If the intrinsic value is only $20/share, it only has to increase 100% to reflect its intrinsic value. Therefore, the larger the margin of safety that exists, the greater safety of principle there is and the higher expected rate of return. This belief is contrary to most investing philosophies that assume one must take on higher risks to achieve greater rates of return. We believe exactly the opposite, that the less risk, the higher the expected rate of return.

This is what makes investing with a large margin of safety such an effective investing methodology. In 1984, Buffett spoke of the now famous “Superinvestors of Graham and Doddsville” , where he described a group of nine investors who all invested using the principle of a margin of safety, and who all beat the market with low risk over a long period of time. For more information, visit this linkhttp://en.wikipedia.org/wiki/The_Superinvestors_of_Graham-and-Doddsville. In this article, Buffett provided convincing evidence as to the safety and high rates of return possible through the use of this style of investing.

Another important concept is that investing with a margin of safety also inadvertently allows investors to sell in markets that are too expensive and therefore risky, and buy in markets that are cheap and therefore low risk. This occurs because as the investor searches for companies, he will only find companies at a steep discount to their intrinsic value in down markets, and in inflated markets will not find any acceptable investment opportunities, and will sell his holdings when they are selling substantially above their intrinsic value. So again using GE as the example, in 2007 when GE was trading for $40/share, we would have sold all of our holdings, since we valued GE at $30/share, but once GE fell substantially below $30/share, we would have started buying again. So in this case our investment methodology would guide us to stay away from the market when common stocks are too expensive, and buy aggressively when they are cheap.

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