"The main underlying principle of value investing is that you should invest in undervalued securities because they alone offer a margin of safety."
This insightful quote from legendary investor Seth Klarman (Trades, Portfolio) perfectly encapsulates his philosophy on investing.
In his acclaimed 1991 book, "Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor," Klarman comprehensively lays out his highly disciplined approach to minimizing risk while maximizing upside through the judicious implementation of the margin of safety concept.
Origin and definition of margin of safety
The notion of margin of safety originated in the field of engineering, where prudent engineers intentionally over-design structures like bridges to allow for unanticipated loads and potential stresses. This intentional "cushion" or margin of safety enables structures to accommodate greater pressures than the expected norm, accounting for potential errors in engineering calculations or unexpected real-world events.
The great investor Benjamin Graham adapted this engineering principle to stock investing and value analysis. For Graham, the margin of safety represents the difference between a stock's purchase price and its estimated intrinsic or true underlying business value. The greater the chasm between the price paid by the investor and the calculated worth of the asset, the larger the built-in margin of safety. This valuation gap provides crucial protection against errors in analysis or unforeseen declines in corporate value.
Value investing vs. speculation
According to Klarman, the margin of safety concept is the key distinction separating value investing from mere speculation. While speculators pay little heed to reasonable valuations, often chasing trends and sentiment-fueled momentum, value investors aim to acquire securities only when there is a sufficient disparity between price and intrinsic worth to provide a meaningful margin of safety.
Klarman's approach to margin of safety
Among practitioners of value investing, few investors put the margin of safety principle into practice as rigorously and consistently as Klarman. His deeply conservative value philosophy targets extremely undervalued, out-of-favor opportunities that appear likely to provide enormous downside protection in addition to tremendous long-term upside potential.
Rather than basing investments on simplistic valuation multiples like price-earnings ratios, Klarman performs exhaustive analysis to arrive at a conservative estimate of intrinsic value. He then aims to invest at a substantial discount to even his most cautious calculated appraisals. While most prudent value investors demand a margin of safety of 20% to 30% below their estimate of fair corporate worth, Klarman sets his sights significantly wider. In "Margin of Safety," he discusses targeting absolute rock-bottom valuations, applying discounts as high as 50% or more to a business' intrinsic value estimate.
Benefits of Klarman's approach
By insisting on such a considerable margin of safety, Klarman secures two key benefits for his investors. First, his portfolio gains tremendous resilience against permanent loss, with plenty of room for unforeseen financial, economic or industry developments. And second, the upside potential over the long run is dramatic when the large valuation gap ultimately closes as fundamentally sound companies increase their business value over time.
Examples from other esteemed investors
While few employ it with the laser-like discipline of Klarman, most emulators of Graham and successors of value investing incorporate some form of the margin of safety principle into their investing processes. Graham himself demanded substantial valuation cushions of 30% or more below his conservative appraisals to invest, although he was far more flexible than Klarman.
Warren Buffett (Trades, Portfolio), Graham's most famous and successful disciple, similarly made acquisitions of both stocks and entire businesses only when they could be obtained at a noteworthy discount to what he believed to be their true intrinsic value. Buffett considered this "margin of safety" the central concept in sound investing.
In his 1988 letter to Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) shareholders, Buffett clearly laid out his value-focused investing methodology, stating that he seeks "an earnings power that even under distress conditions seems likely to continue to an adequate return on the equity capital required." In other words, Buffett tries to buy at prices low enough to provide confidence in an acceptable return even if the business falls on hard times.
Like his mentee Klarman, Buffett saw risk primarily as the possibility of paying too high a price rather than stock price volatility. By consistently acquiring stocks and companies at prices appreciably below his conservative appraisals, Buffett’s discipline has paid enormous dividends. In the 58 years since he took control of Berkshire Hathaway in 1965, its per-share market value has mushroomed at a 20.1% annual rate compared to a 9.7% return for the S&P 500 Index over the same period.
How to implement margin of safety in your portfolio
For ordinary investors, the key to successfully implementing an adequate margin of safety within your own portfolio includes:
- Research: Perform in-depth fundamental analysis on investment candidates to arrive at a conservative estimate of intrinsic value based on both quantitative and qualitative factors. Avoid over-reliance on simplistic or shorthand valuation measures.
- Conservatism: When valuing companies, heavily discount projections, assume conservative growth rates, incorporate generous margins for industry uncertainties and prepare for unfavorable scenarios.
- Patience: Remain disciplined and willing to hold cash while waiting patiently for the right opportunities. Do not compromise your margin of safety requirements regardless of anxiety about remaining invested.
- Discounts: Only invest when stock prices represent discounts of 35% to 50% or more compared to your conservative appraisal of intrinsic value. This wide margin of safety creates a robust buffer.
- Discipline: Adhere strictly to your required margin of safety at all times, ignoring macroeconomic forecasts, market trends, or emotions like fear and greed. Don't overpay simply because stocks seem popular.
Benefits of incorporating a sizable margin of safety
Incorporating a sufficient margin of safety into one's investing approach provides several profound benefits:
- Downside protection: A large margin of safety serves to minimize potential losses, even in cases where actual business value deteriorates and turns out substantially lower than original estimates.
- Room for error: A margin of safety allows crucial breathing room in case of mistakes in analysis or overly optimistic financial projections and assumptions.
- Capitalizing on volatility: A valuation cushion enables opportunistically taking advantage of irrational price declines unrelated to business fundamentals by increasing positions on dips and swoons.
- Imposes rationality: Requiring a margin of safety instills rigorous discipline, patience, objectivity and rationality by preventing reaction to ephemeral market noise and emotions.
- True risk management: While conventional definitions of "risk" focus narrowly on volatility, incorporating a margin of safety manages risk through an emphasis on prudent valuation.
- Maximizing rewards: When the significant valuation difference eventually closes as fundamentally good companies grow their business value over time, the upside potential is substantial.
A mindset, not just a strategy
Klarman staunchly follows the value investing principles of Graham, insisting on a substantial margin of safety when acquiring stocks. This margin of safety provides a considerable cushion against loss in case of analytical errors or business underperformance.
While few investors implement it with Klarman's rigor, the margin of safety remains a fundamental concept for long-term value investors. By being deeply contrarian and only buying at bargain valuations, Klarman exhibits remarkable discipline and rationality. His philosophy offers like-minded investors a prudent framework for minimizing risk and maximizing reward through the consistent use of a margin of safety.
