Dec 14 2006
Does The Business Have Margin of Safety?
“In the short run the stock market is a voting machine but in the long run it’s a weighing machine.” — Benjamin Graham, author, The Intelligent Investor
“The basic ideas of investing are to look at stocks as businesses, use market fluctuations to your advantage and seek a Margin of Safety: That’s what Ben Graham taught us. A hundred years from now they will still the be the cornerstones of investing.” — Warren Buffett, CEO, Berkshire Hathaway
Rule #1 investing is all about buying $1 of value on the stock market for 50 cents or less. This is possible because the value of a business is not always accurately reflected in its current asking price. For a whole host of reasons, from time to time the asking price of a business will be below its actual sticker price. By buying shares at those times, you automatically build in a margin of safety for your investments.
This is why private investors can always beat the returns generated by mutual fund managers. A private investor can sit on his hands and bide his time indefinitely while the asking price of a Rule #1 stock is too high. There is no pressure to act. A mutual fund manager doesn’t have that flexibility, because his or her contributors are expecting to see more action rather than a static bank balance. Therefore, the fund manager is compelled to act, even if the market conditions don’t warrant doing anything. A private investor misses these pressures completely.
You make your money in investing when you buy your stocks, not when you sell them. If you buy stocks for 50 cents each that are actually worth $1, then you’re going to make a fantastic return when the market gets around to pricing those stocks more realistically. This is the essence of the concept of a margin of safety. The greater the discount you’re buying a stock at in comparison with its true value, the greater your margin of safety becomes. In practice, you should always aim to buy stocks at half their sticker price.
Note that a margin of safety does not exist in isolation. Before you can safely say you have a margin of safety, you have to do an entire analysis. You have to identify a business that passes the other three filtering questions. You have to know the Big Five numbers for your potential purchase and be able to articulate what the company’s moat is. You have to be satisfied that a strong management team led by a great CEO is in place. All of this analysis precedes any discussion of a margin of safety.
When used correctly, the margin of safety concept will make you millions of dollars while at the same time keeping you from losing money when things don’t go as planned. You won’t get caught up in examples of stock market bubbles or periods of irrational exuberance. Instead, Rule #1 investing will keep you in the sweet spot of investing profitability.