The cornerstone of investment success

Margin of safety

The wise men finally boiled down the history of mortal affairs into the single phrase

Warren Buffett says: “We believe this margin of safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.” It’s worth learning about. There are some nuances.

Let me introduce the subject by making a point about what a portfolio in which all the stocks have been bought with a margin of safety, will look like.

The companies should have great prospects for growth. Each stock in this well-balanced diversified portfolio should have been purchased for the long term. Let’s say there are twenty stocks in the portfolio. Only a handful will have been purchased in the last two or three years. Those recent purchases will have been bought at bargain prices; that is, at prices well below intrinsic value. Most of the remaining fifteen or seventeen stocks in the portfolio will be fully priced and some may be priced well over intrinsic value.

Some of the recently purchased stocks may have low price earnings ratios because of temporary negative business news that brought the stock price below fair value in the first place. Some may have higher price earnings ratios because earnings are temporarily depressed. One could not look at the portfolio and say: “Oh that is a value portfolio – I can see those are value stocks”. Yet, every single stock will have been purchased with a margin of safety.

Prices and values

How is this possible? The answer is simple: “Share prices fluctuate more widely than values”. This is the way John Templeton puts it in his Maxim 13.

Chapter 20 in The Intelligent Investor by Benjamin Graham is titled ‘“Margin of Safety” as the Central Concept of Investment’. Benjamin Graham put it this way: “In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, “This too will pass.” Confronted with a like challenge to distill the secrets of sound investment into three words, we venture the motto, MARGIN OF SAFETY. This is the thread that runs through all the preceding discussion of investment policy – often explicitly, sometimes in a less direct fashion.” (Graham, 1973)p.277.

Warren Buffett, after referring to the difficulties everyone has in valuing companies says: “At Berkshire, we attempt to deal with this problem in two ways. First, we try to stick to businesses we understand. That means they must be relatively simple and stable in character….Second, and equally import, 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, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.” (Buffett/Cunningham, 1998, p.87) (emphasis added)

Berkshire Hathaway forced to compromise

It is interesting to note that Warren Buffett has been forced to compromise this cornerstone principle somewhat because of the size of Berkshire Hathaway. As noted earlier he has written: “we now substitute ‘an attractive price’ for ‘a very attractive price’.” (Buffett, 1998, p.85) The individual investor is not burdened by this problem. There should be no compromise on the ‘very attractive price’.

Timing by way of price

There is a threshold issue. We need to think about whether buying with a margin of safety is really the closet practice of market timing.

Market timing is the effort to buy a stock or stocks when the outlook is good and sell them when the outlook darkens. It is one of the most sure fire ways of losing money in the stock market. It comes freighted with all the perils of behavioral biases.

Benjamin Graham makes a distinction between ‘the way of timing’ and ‘the way of pricing’. He writes:

“Since common stock, even of investment grade, are subject to recurrent and wide fluctuations in their prices, the intelligent investor should be interested in the possibilities of profiting from these pendulum swings. There are two possible ways by which he may try to do this: the way of timing and the way of pricing. By timing we mean the endeavor to anticipate the action of the stock market – to buy or hold when the future course is deemed to be upward, to sell or refrain from buying when the course is downward. By pricing we mean the endeavor to buy stocks when they are quoted below their fair value and to sell them when they rise above such value.” (Graham, 1973)p.95.

This quote makes clear that the way of pricing is not the practice of market timing. Graham goes on to develop his thesis of the way of pricing and ultimately calls it buying with a margin of safety.

How can prices and value diverge?

The big question is how one goes about buying superb companies whose stock price is temporarily depressed. Almost by definition a stock selling at a bargain price is highly unpopular. Therein lies the rub. The sections to Chapter 26 referred to after the summing up section help answer this question.

Summing up

As a way of summing up our discussion of margin of safety and tying these ideas together, it may be useful to review two of John Templeton’s 21 Maxims.

13. Share prices fluctuate more widely than values. Therefore, index funds will never produce the best total return performance.

14. Too many investors focus on “outlook” and “trend.” Therefore, more profit is made by focusing on value. (Proctor & Phillips, The Templeton Touch, 1983, 2012)p.153.

Reflecting on Maxim 13, it is also true that there are many more opportunities to buy individual companies at bargain prices than to buy a market index fund at bargain prices. This is because even in good economic times and strong stock markets there are usually individual stocks or stock sectors or industries that are in the doghouse.

This is the reason an investor in individual companies will do better than an index investor, even one who switches from one sectoral fund to another periodically.

Mispricing will occur. As a result we will often have opportunities to buy with a margin of safety. In our chapter 8. The Economy and the Stock Market – Cycles and Trends, we noted that cycles in the stock market occur. We do not need to be able to predict when they will occur. That is impossible.

As well, we do not need to predict when stock bull markets will happen. We do not need to predict where the stock market will be in two or five or even ten years.

We just know that with patience and time our well-chosen portfolio of superb stocks bought at very advantageous prices will move higher and generate a superior return.

To read further on this subject take a look at these sections in Chapter 26

26.01 Timing by way of pricing

26.02 In the doghouse and woebegone regions

26.03 Some of the reasons stocks may sell at bargain prices

26.04 Margin of safety and company quality

26.05 Margin of safety leads to superior returns

26.06 Waiting for a soft pitch in the happy zone

26.07 Margin of safety and point of maximum pessimism

26.08 Keep it simple but do your homework

26.09 Value traps

26.10 Graham’s net nets

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