Let me start this article with a quote by Charlie Munger:
“No matter how wonderful [a business] is, it’s not worth an infinite price. We have to have a price that makes sense and gives a margin of safety considering the normal vicissitudes of life.”
So, the general principle of margin of safety means that when you are done with your thorough analysis of the company and deciding what the company is current worth for, you further discount it. It acts just as a precaution for any error you could have made in your analysis.
Margin of Safety has been there for a long time and it can be present in any situation. Look at this quote from Warren Buffett:
“You have to have the knowledge to enable you to make a very general estimate about the value of the underlying business. But you do not cut it close. That is what Ben Graham meant by having a margin of safety. You don’t try to buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And that same principle works in investing.“
Here is one more:
“If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. So, the more vulnerable the business is, assuming you still want to invest in it, the larger margin of safety you’d need. If you’re driving a truck across a bridge that says it holds 10,000 pounds and you’ve got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay, but if it’s over the Grand Canyon, you may feel you want a little larger margin of safety.“
You carrying a power bank when you still think that your phone could survive the day or carrying extra cash to the market as in case you are short on money.
These are some few daily examples where we use the concept of margin of safety.
But use of it in the world of investing was coined by Benjamin Graham in the chapter 20 of his book The Intelligent Investor. Since then this concept has made investing a little bit stress free for many people.
Okay so the concept seems good but why do you need margin of safety when you think you have done a good analysis?
Here is a tweet from Ian Cassel which answers that for you:
Widening Of The Concept
The world is changing very fast these days. As the technology keeps on getting better day by day.
Everyday we have someone claiming that they have a faster and better way of doing something which the previous technology could not do.
One day the social media market is fully dominated with only one app and suddenly within few months there is a new king.
So when such things are happening around, just getting a safety on the basis of price is not enough. You need more than that which can protect you from permanent capital loss.
That’s when the quality of the business plays a huge role and stands there as a margin of safety for your investment.
This is not something which I have come up with many investors like Prof. Sanjay Bakshi and Vishal Khandewal do use such safety.
Margin of Safety as per Prof. Sanjay Bakshi
For example in article My Email Exchange with Prof. Sanjay Bakshi on Valuations, Prof. Sanjay Bakshi mentions that his valuation method is divided into three stages and each stage provides him with a margin of safety,
- Selecting a quality business which is guarded by a Moat.
- Being conservative while making assumptions about owner earnings a decade later.
- Using a exit multiple of well below 20x, even when he knows that business would be worth more than that after a decade.
All these three steps acts as a margin of safety for Prof. Sanjay Bakshi.
Margin of as per Vishal Khandewal
Here are two videos where he talks his view on the concept…
He talks about quality of business as margin of safety from 04:22 - link
Here it starts from 09:33 - link
So, I hope the idea of quality of a business acting as margin of safety is clear.
Here Is What I Do
I try to implement margin of safety into three ways similar to Prof. Sanjay Bakshi:
- Being inside my Circle of Competence
- Looking for a business with an enduring Moat
- At a reasonable valuation which is further discounted at a conservative discount rate.
Let try to understand it again with a small example:
Looking at food consumption business, it is quite far fetched that such industry could be disrupted suddenly.
Even if the technology changes every month it highly unlikely that it would change the way how people consume their food.
Better or newer technology won’t change how people eat or what are their taste preference.(not yet I guess!)
This is one of the reasons why Warren Buffett likes his See’s Candies investment. As faster or better technology wont change the people’s preference for chocolate they most like.
But we need to remember that, business quality alone cannot be a margin of safety, the business must be available at a ‘fair’ valuation.