Here’s an explanation of Ben Graham’s concept of ‘margin of safety’

Reuters/Mike SegarItaly’s Elena Fanchini gets tangled in the safety net after crashing in the first training session for the women’s alpine skiing downhill event during the 2014 Sochi Winter Olympics at the Rosa Khutor Alpine Center.

The concept of “margin of safety” – which originates from Benjamin Graham’s earliest teachings – is a core tenet of value investing.

As Graham wrote in the very last chapter of The Intelligent Investor (Chapter 20:“Margin of Safety” as the Central Concept of Investment):

Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.

The beauty of “margin of safety” lies in both the concept’s simplicity and in its effectiveness in protecting investors from making big mistakes.

Graham really was a pioneer in behavioral finance before behavioral finance was even a thing, and the margin of safety concept was one of the first tools that allowed investors to overcome their own biases, creating a protection against the “unknown unknowns” of an investment.

SO WHAT IS MARGIN OF SAFETY?

Margin of safety is a very easy concept to understand.

As Ben Graham points out, “all experienced investors recognize that the margin-of-safety concept is essential to the choice of sound bonds.”

For example, if you are investing in a bond, you would probably want to make sure that the company has historically generated enough cash flow to cover interest payments and other fixed charges 3-times, 4-times, or even 5-times over in any given year.

Graham continues:

This past ability to earn in excess of interest requirements constitutes the margin of safety that is counted on to protect the investor against loss or discomfiture in the event of some future decline in net income… The margin above charges may be stated in other ways – for example, in the percentage by which revenues or profits may decline before the balance after interest disappears – but the underlying idea remains the same.

This makes sense, right?

A bank wouldn’t loan loan you money if you could only just barely pay the interest every month. They’d want there to be some cushion in case something goes wrong in the future (you lose your job, you get sick, etc.)

Graham simply took this simple fixed income concept and applied it to all assets, including stocks.

According to Graham:

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.

And, of course:

REUTERS/Jana AsenbrennerovaSan Francisco’s Golden Gate Bridge.

WARREN BUFFETT’S BRIDGE ANALOGY

Warren Buffett – Ben Graham’s most famous and most successful disciple – compares margin of safety to driving across a bridge:

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.

I love this analogy, and Warren Buffett has used it multiple times:

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…

WHAT IS MARGIN OF SAFETY ACCORDING TO SETH KLARMAN

Legendary value investor and founder of the Baupost Group hedge fund Seth Klarman (seeBenjamin Graham: The Father of Value Investing and His Family) published an entire book devoted to the subject of margin of safety in 1991: Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor.

The book, by the way, is out of print but is currently selling on eBay and Amazon for over $1,000 (not including $5 shipping & handling, of course). Luckily, Klarman’s book can be found through various (nefarious?) sources online, including here.

Getty Images/ Scott OlsonSeth Klarman, president and CEO of the The Baupost Group

According to Klarman:

A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world.

And how does Klarman think intelligent value investors can make sure they have a margin of safety?

By always buying at a significant discount to underlying business value, and giving preference to tangible assets over intangibles. (This does not mean that there are not excellent investment opportunities in businesses with valuable intangible assets.)… Since investors cannot predict when values will rise or fall, valuation should always be performed conservatively, giving considerable weight to worst-case liquidation value as well as to other methods.

THE FAULT, DEAR BRUTUS, IS NOT IN OUR STARS, BUT IN OURSELVES

In the introduction to The Intelligent Investor, Ben Graham writes:

What then will we aim to accomplish in this book? Our main objective will be to guide the reader against the areas of possible substantial error and to develop policies with which he will be comfortable… For indeed, the investor’s chief problem – and even his worst enemy – is likely to be himself… “The fault, dear investor, is not in our stars – and not in our stocks – but in ourselves…”

The margin of safety – one of the core principles of value investing – accomplishes exactly that, protecting us both from ourselves and from whatever unforeseen events the “stars” above might throw at our investments in the unpredictable future.

Read the original article on Vintage Value Investing. Visit Vintage Value Investing today to learn more about the investing secrets of Ben Graham, Warren Buffett, and Charlie Munger. You can also check out Vintage Value Investing on Facebook and Twitter. Copyright 2016. Follow Vintage Value Investing on Twitter.