20. Margin of Safety as a Central Concept

The market, like the companies it represents, will wax and wane over time, as business enterprises that are represented by securities have a lifespan: they begin small, grow, experience a period of prosperity, then decline. As such, it becomes necessary for the defensive investor to seek some margin of safety in their investments.

The bond investor is naturally drawn to favor stability: his is a long-term investment that will not fare better if the firm to whom he has issued credit experiences heightened prosperity - his maximum income is what he was promised in the bond itself: a fixed rate of interest and return of capital after some period of many years.

At the same time, the bondholder must take interest in the long-term welfare of the firm, because he stands to earn less on his investment if the company suffers a loss that leaves it unable to service its debt obligations, and even the principle of the bond may be lost at least in part if the firm experiences an utter collapse.

To that end, the bondholder seeks a margin of safety - the firm must perform well enough to cover its expenses of operation and service its debt, but a little more as well as a method of ensuring that the firm can afford to take a little loss in revenues and still remain solvent. The enterprise value is of concern (ensuring the preservation of principle in assets) as is the times-interest-earned figure (ensuring its ability to easily service its debt).

The same principles can be applied to the common stock of a firm: while stockholders count on the market to set the price for shares in the firm, it is the underlying enterprise value is the only objective and logical basis for that price, and the generation of income above its obligations enables the firm to either pay dividends or invest in the growth of the enterprise. If he can avoid buying at a price that has been unduly inflated by speculation, he can feel reasonably assured that the profit he will make over a long period of time reflects the financial stability of the firm.

For ordinary common stock, the growth in value relies upon the firm earning more than the going rate for bonds - the entire point of owning stocks is to offset the erosion of value that is caused by inflation: bonds represent a fixed payment in depreciating dollars. If the returns on stock were no greater, there would be no incentive to assume the risk of owning them.

Paying too high a price for stocks is a significant hazard, but not the chief hazard of investing in this vehicle. Observation over many years has led the author to conclude that the main cause of investment loss is those who are drawn to low-quality securities at times of favorable business conditions. Two or three years of excellent growth and outstanding profit give the impression of financial strength that is not sustainable, and that fades quickly when the market conditions wane.

Such securities do not offer an adequate margin of safety in the long run: they can cover interest charges and pay dividends easily over a short period of time only. A fair-weather investment, even at a fair-weather price, fares as well as the weather, and declines or collapses when clods appear on the horizon - and often sooner than that. Neither can the investor count on their eventually recovery, though some firms can recover, many never do. As such, one must consider the margin of safety in adverse conditions, as the very notion of safety requires a firm to protect its value in such conditions.

The philosophy of the aggressive investor contravenes the margin of safety principle: he seeks a firm that has unusual earning power, greater than it has shown in the past, regardless if whether it may be sustained in future. As such, he marginalizes or ignores the past record of a firm in considering a choice of investments, turning instead to the estimation of future earnings- and all such predictions are based on specious reasoning, based on the fact that there are issues in the market at any given time that are both overpriced and underpriced when measured by the same criteria.

This is exactly the danger of aggressive investment: the investor must match his predictions against those of others in the market: sellers whose willingness to part with a security have less favorable predictions of future value, buyers who are willing to pay more have a more favorable prediction. Thus, the more people feel that an investment will do well in future, the higher its price, and the greater the loss will be taken when the hope based on such feelings is unfulfilled.

As such, an aggressive investor who wishes some margin of safety must be more conservative than others in his approximation of future performance, and count of sellers at the time he buys to be even more pessimistic than himself and buyers in the future when he is selling to be even more optimistic than himself.

H2> Diversification


The practice of diversification is closely related to the desire for a margin of safety, and is an established tenet of conservative investing: it is simply a matter of spreading risk among firms, with the knowledge that some will fail and others succeed, and overall risk will be mitigated by the failure of some and the success of others.

This principle is the basis of insurance underwriting, a practice at which some firms have enjoyed success over a period of centuries, even through disaster.

However, while diversification is useful in safeguarding the value of a portfolio, it is not a substitute for sound investment analysis.: a diversified portfolio of overpriced and financially unsound firms that can be counted upon to lose value will perform better than the worst of the lot, but will still lose value overall.

Differentiating Investment from Speculation

There is no single and universal definition of investment or speculation, so the "authorities" on such matters tend to adjust the definition as they please, to grant their ideas the dignity of investment and avoid the stigma of being speculation - and ultimately to bamboozle those whose trust they desire to gain.

The author suggests that the margin-of-safety concept may be a touchstone to distinguish between the two. That is, the nature of speculation is to seek to gain the maximum return heedless of the risk posed, whereas investors seek to gain a reasonable return while taking on minimal risk.

As such, the author considers any "true investment" to be made with regard to the risk and margin of safety - one that is demonstrated by figures, persuasive reasoning, and a body of actual experience.

Unconventional Investments

The body of conventional investments includes federal, municipal, and commercial bonds as well as common stocks. Beyond that, there is a fairly wide assortment of unconventional investments, which the author maintains should be avoided by the conservative investor.

The broadest category of such investments would be the undervalued stocks of secondary companies, low-grade corporate bonds, preferred stocks selling at depressed prices. These are generally the milieu of the speculator.

However, it is considered that a sufficiently low price can turn a security of mediocre quality into a sound investment opportunity. Again, this goes to the notion of a margin of safety required by investors.

For example, the real estate bonds issued in the 1920's had very little margin over the value of their debt, making them highly speculative. However, in the depression of the following decade, the price of these issues collapsed, to the point that some were selling at 10 cents on the dollar - at which price they could be considered relatively safe because the backing value of the real estate was four to five times that amount.

Some turned huge profits on such investments, and were labeled as speculators by the financial press - but turning a large profit on an investment does not mean it is speculative. The criteria for speculation is low value in proportion to price, and as these bonds had significant value in proportion to price, they qualified as investment-grade - though those who purchased them a decade earlier, when the value-to-price ratio was much less favorable.

The same is true of virtually any sort of investment, even those deemed extremely risky: if the price is low enough, just about anything becomes a good enough deal for the conservative investor.

To Sum Up

Generally, the difference between investment and speculation is characterized by the difference between the businessman and the gambler. There is a certain risk in any business enterprise - and an investor approaches any opportunity to purchase into a business with as much discretion and sobriety as if he were embarking on a business venture of his own.

The first principle of investing is therefore to know what you are doing, and know your business. Do not attempt to make profits out of securities unless you know as much about the values as you would need to know about a business you would be prepared to operate yourself.

The second principle is: do not let anyone else run your business, unless you can supervise his performance with adequate care or have unusually strong reasons for placing confidence in his integrity an ability.

A third principle: do not invest in an operation unless a reliable calculation determines it has a fair chance to yield a reasonable profit. In particular, avoid operations in which you have little to gain and much to lose. Certainty of modest returns is to be preferred over the scant possibility of stellar performance.

Fourth, have the courage to trust in your own knowledge and experience. If you have been diligent in fact-finding and applied sound judgment, act on it, even if others hesitate. You are neither right nor wrong because the crowd disagrees with your reasoning - in fact, your greatest profits will come when they come around to your way of thinking.

None of this is beyond the abilities of the average person: to achieve satisfactory results from investment is much easier than most people realize, but to achieve superior results is harder than many seem to suppose.