Chapter 20: The “Margin of Safety” as a Central Concept of Investment
**Quick update** Thanks for reading, I’ve compiled this entire series into an electronic copy that you can take offline → here
Welcome back to the Intelligent Investor series. In this chapter of The Intelligent Investor, Graham revisits the core of the text which is the “Margin of Safety”. The Margin of Safety is the single-most important concept that Graham speaks about throughout the book and is at the heart of the Value Investing Philosophy. Here’s the list of preceding posts if you’d like to get caught up:
- Intro and Chapter 1 , Chapter 2, Chapter 3, Chapter 4, Chapter 5, Chapter 6, Chapter 7, Chapter 8, Chapter 9, Chapter 10, Chapter 11, Chapter 12, Chapter 13, Chapter 14, Chapter 15, Chapter 16, Chapter 17, Chapter 18, Chapter 19
The major point about the margin of safety is that it removes the speculator’s need to predict the future, thus turning that speculator into an investor. Graham said it best:
The function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future. If the margin is a large one, then it is enough to assume that future earnings will not fall far below those of the past in order for an investor to feel sufficiently protected against the vicissitudes of time.
Something of note is that when Graham identifies a margin of safety, he isn’t just talking about an issue that is solely undervalued. Often, he can site examples of a stock issue that is selling for less than the amount of some other asset on the balance sheet. An example would be if he were looking at a stock issue that had a good margin of safety because it was selling at a depressed condition for less than the amount of bonds that could safely be issued against it’s property and earning power. In this case, the investor could buy the stock; achieving the safety associated with the bond, plus all the chances of larger income and principal appreciation inherent in the common stock.
Graham breaks the margin of safety down by comparing a stock issue with an earnings power of 9% / annum over bond interest rates at 4%. In this case, the margin is 5% / annum for this stock issue. At this point, the investor is able to see that he has over 100% margin of safety because, 5% > 4% and therefore, with the cash dividends from the issue, should expect a 50% total margin over bonds if the stock is held for 10 years. That 50% becomes your margin of safety. When stocks earnings and bond interest rates are near equal, your margin of safety is diminished. He states that including examples of buys in your portfolio in a diversified manner, one should expect not to have to look into the future but to focus only on good buys. Graham adds that often the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.
Adding that the margin of safety is even more obvious when one talks about buying bargain issues. Here we see another form of the margin of safety take shape. One is wise to point out that Graham continues to tout diversification with these buys as well. His words here are that having a good margin of safety increases you chances of profits over a loss, but does not remove the possibility of a loss. Graham finalizes, that “the investor’s concept of the margin of safety rests upon simple and definite arithmetical reasoning from statistical data.”
To have a true investment, there must be present a true margin of safety. And a true margin of safety is one that can be demonstrated by figures, by persuasive reasoning, and by reference to a body of actual experience.
Graham recommends that if an enterprising investor wanted to try the unconventional investment of undervalued common stocks of secondary companies, he should only do so if they can be bought at two-thirds or less of their indicated value. So long as the investment price includes a substantial margin of safety, the issue can be considered an investment.
Graham’s Summarizes the principals of business
He recommends that many successfully established business people should remember the sound principals that have caused them success in business when they choose to invest.
Principle 1: “Know what you are doing — know your business.”
Principle 2: “Don’t let anyone else run your business, unless (1) you can supervise his performance with adequate care and comprehension or (2) you have unusually strong reasons for placing implicit confidence in his integrity and ability.”
Principle 3: “Don’t enter upon an operation — that is , manufacturing or trading an item — unless a reliable calculation shows that it has a fair chance to yield a reasonable profit.
Principle 4: “ Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it — even though others may hesitate or differ.”
The Intelligent Investor has been the best investment book I’ve read to date. Benjamin Graham does a thorough job of opening the investor’s mind to many questions they may not have considered before. If you would like to discuss the materials or delve deeper into a topic, let me know on twitter @DavidCappelucci.
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-David
