”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…”
The above quote comes from Warren Buffett and Berkshire Hathaway’s annual shareholder’s meeting, in 1997. It is an analogy on how you should think, about the Margin of safety, to become successful as an investor. And since it seems to have worked well for Warren, I think we should delve a little deeper into this concept.
I have researched and studied the concept of a ”Margin of safety” for years now. And to be frank, it would be quite hard to use fundamental analysis successfully without it. Because it reduces risk, while it at the same time creates the potential for a huge upside. Which is why it is one of the most important things to understand in investing.
I personally learned about the margin of safety concept before I ventured out into more complex valuation models. And I think that has benefited me as a trader, because the concept is simple and it gives you a foundation and a cushion if you are wrong in your investment thesis. In addition, simple methods are often better. The hard part is to stick to them. Because simple is not the same as easy. Which might be the cause of the confusion that surrounds the idea of a margin of safety. So let’s dissolve that confusion.
Buying one dollar bills for 50 cents
Charlie Munger has stated that he and Warren Buffett likes to buy one dollar bills for 50 cents. But even better is if that one dollar bill is growing. And if it creates a larger pile over time. Further, it is this concept, of buying great businesses for half their intrinsic value, that has guided his and Warren’s approach for over half a century. Further, it is the basis for all value investing. But to apply a margin of safety you first need to know the intrinsic value of the investment.
An intrinsic value could be many things. For example, it could be the strike price of an option. It could be the fair value of a house, in relation to its current conditions, like inflation, supply and demand. But in this post it relates to stock investing. And the original source of the term comes from the father of value investing, Benjamin Graham, who was the mentor of Warren Buffett.
Margin of safety and Intrinsic value
Grahams most famous book is The Intelligent investor, from 1949. In The Intelligent investor he goes deep into the concept of a margin of safety and how to buy stocks for less than their intrinsic value. Warren Buffett has stated that this book was elemental in making him the investor he is today. And since he is probably the best fundamental investor in all of time, we should listen to what he has to say.
But to understand the concept of Intrinsic value another book by Graham is even more important than The Intelligent investor. And that is Security analysis, from 1934, which Graham coauthored with David L. Dodd. In Security analysis he delves deep into the term intrinsic value. And in it he describes how to calculate the Intrinsic value and how it can be used for valuing stocks.
What is the intrinsic value?
According to Graham the Intrinsic value is that which can be measured as capital in the business. For example assets, earnings, profits and real estate. But also a brand name and the cost structure can be a part of the Intrinsic value. Now, Graham was a pure fundamental investor and he did not believe in other methods. For example, he did not believe in technical analysis and sentiment as valuable indicators. But the reason for that might be that he never tried to master these areas. Because he was already an accomplished fundamental analyst. And he sure knew his fundamental analysis.
The weighing machine
Graham thought that in the long run stock prices will reflect their fundamental value. And in this regard he reminds me of Peter lynch, who wrote that the stock price and earnings have an exact correlation in the long run, in his book One up on Wall Street. A famous quote by Graham goes like this:
“In the short run, the market is a voting machine but in the long run, it is a weighing machine.”
Graham thought that emotions has a say in the short term but not in the long run. In the long run the substance, and the true fundamental value, of a company is more important. But he did not think the intrinsic value could be pinned down to an exact number.
“We must recognize, however, that intrinsic value is an elusive concept. In general terms it is understood to be that value which is justified by the facts, e.g., the assets, earnings, dividends, definite prospects, as distinct, let us say, from market quotations established by artificial manipulation or distorted by psychological excesses” – Benjamin Graham, in Security Analysis
The inexact science
The intrinsic value cannot be pinned down to an exact number, according to Graham. Because the price is always affected partly by reason, and partly by emotion. Therefore the calculation for intrinsic value is not an exact science. But rather a price interval where the stock is fairly valued. As a result the buying price must always be substanstially below this interval to qualify as a robust margin of safety. Which is illustrated by the picture below.
There are many ways to calculate the intrinsic value of a stock. And different investors do this differently. Graham described several methods in his books. For example he looked at the stock price, dividends and earnings per share. But the most famous of his calculations is the Net asset value, or NAV calculation. Also called Net current asset value, or NCAV calculation.
The stocks that are selling below their NCAV value are called “Net nets” by deep value investors. These companies are the hated ugly ducklings that most investors won’t touch. Because when a company is selling below its NAV it is in reality trading below its liquidation value. Which means they are very cheap. But also risky.
Current assets – current liabilities + (long term liabilities + preferred stock) / outstanding stocks = NCAV per stock.
This can also be calculated in a faster way by taking current assets minus total liabilities. The second way, in which he calculated Net nets, is often called the Net net working capital calculation, and is a more conservative calculation to find even cheaper stocks. The calculation goes like this:
100% cash and short term liabilities + 75% accounts receivables + 50% inventories – 100% of all liabilities = Net net working capital, NNWC.
Graham did not think that assets alone gave a complete picture of the intrinsic value. Or that the earnings power of a company could be pinned down to an exact number. The truth is that he used many methods to come up with an intrinsic value. For example, earnings, earnings power, dividends and his ten points method. He described most of these methods in his books, Security analysis and The intelligent investor.
Graham thought that a good margin of safety was to buy Net nets when they were trading at two thirds of NCAV. But for NNWC it could be a bit higher. Although NCAV is more commonly used. Because it is harder to find NNWC-stocks. Especially in strong markets.
Look for strong net nets
When picking Net nets it is important to look for creditworthy businesses. They should have low long term debt. Because companies without debt seldom go bankrupt. Further, Net nets are usually small cap stocks. As a result bigger investors, like Buffett, usually don’t bother to invest in them. Because they are too small to make an impact on their portfolios. But that also means that smaller investors have an advantage when it comes to these stocks.
Net nets are not as common in bull markets, as the one we are currently in at the time of writing, in early 2020. As a result other calculations might be more appropriate right now. For example, growth based approaches. And that leads us to the next man that has influenced the Intrinsic value concept, but from another perspective, Philip Fisher.
Warren Buffet has stated that he is around 85 percent Graham and 15 percent Philip Fisher. And he has said that Philip Fisher’s book Common stocks and uncommon profits, was a ” very very good book”. Philip Fisher is not as well-known as Benjamin Graham. But he was an ingenious growth investor who popularized the method of ”scuttlebutting”. Scuttlebutting is a method that consists of asking a company clever and savvy questions about the business, to obtain precious information.
Fisher was more growth focused than Graham, and that influence is evident in Warren Buffett’s strategy as well. But even Fisher said that growth of earnings can be an unreliable predictor of the future. Therefore I think it is wise to combine the growth strategies of Fisher with the quant strategies of Benjamin Graham, to make good investment decisions. Which is also what Warren Buffett and Charlie Munger advocates. And what they have been doing for over half a century.
Warren Buffett’s calculation
Warren Buffett focus more on the quality of cash flows and earnings, than what both Graham and Fisher did. Which might be the result of the size he is managing. Because he cannot easily get in and out of investments. Because he is managing over a 100 billion dollars. He has to look for stable, well run businesses with predictable income streams that are going to give him few surprises. But in his early investing career years he was investing money in Net net stocks. And maybe that is the reason why his biggest returns came in those early years. But nowadays he is more focused on earnings power and cash flows.
Buffett has said that the intrinsic value is the discounted value of the cash that can be taken out of a business, during its remaining life. But Buffett, like Graham, thinks of this as an estimate and not an exact number. Buffett also thinks that the intrinsic value can change. For example if the cash and earnings estimates are revised. Or if national interest rates changes.
The theory of investment value
Buffett has mentioned that the economists John Burr Williams and Irving Fisher has been influential on his investing style. John Burr Williams wrote The theory of Investment value in 1938. Irving Fisher wrote The theory of interest in 1930. These two economists were the first to express the Discounted cash flow model in modern economic terms. And Buffett has been influenced by both of them. But he does not follow these models rigidly. Because he relies more on his own genius than on single models.
”In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.” – Warren Buffett, in his Letters to shareholders, in 1991.
An example of how Buffett used discounted cash flows, in his own way, is described in “The Warren Buffett way“, a book written by Robert Hagstrom. The book tells the story of how Buffett bought Coca Cola, in the 1980s. The P/E of Coca Cola was around 15, at the time, which is not extremely cheap. But Buffett realized that the margins of Coca Cola were expanding and that the stock was actually very cheap based on that. He thought that this would lead to a higher intrinsic value in the future. Because the cash flows were ramping up. And he came to the conclusion that a margin of safety existed at the present level because of these factors.
Buffett realized that even a small increase in revenue would make a huge impact on Coca Cola. But that a big increase could make the cash flows explode. In the end he was proven right.
To a technamentalist like myself the Coca Cola chart above looks very interesting. And I think the future of Coca Cola might be bright.
At the time of writing Buffett has banked a profit of 1 750 percent, on the investment in Coca Cola. A Buffett statement on Intrinsic value summarizes this investment very well:
“Intrinsic value is the number, that if you were all knowing about the future and you could predict all the cash a business would give you between now and judgement day, discounted at the proper discount rate, that number is what the intrinsic value of the business is. In other words, the only reason for making an investment and laying out money now is to get back more money later on. That’s what investing is all about.” – Warren Buffett
Another great investment was when he bought See’s candy in 1972. And out of all Buffett-investments this is my personal favourite. Because I think this was an almost perfect investment. And it illustrates how smart Buffett is when he looks “through earnings” to understand businesses. Buffett bought See’s candy for 25 million dollars and it is now estimated to be worth over 700 million dollars. In addition, See’s candy sends him a dividend of over 65 million dollars every year. A dividend almost three times as big as his initial purchase price. Over time, he has received over two billion dollars in dividends from See’s.
When he bought See’s it was making a profit of five million dollars a year and the P/E was five. See’s have low capital requirements because of fast production and distribution times. Therefore almost all of its profits end up as free cash flow in the pockets of Warren Buffett. And he has been able to reinvest those cash flows into other businesses over the years.
In the clip below Buffett talks about some of the things he looks for, to find wonderful businesses.
How to calculate the intrinsic value
There is a lot of debate around how Warren Buffett calculates intrinsic value. But the truth is that he likely uses a multitude of methods. We know that he does most of his analysis on paper and not on a computer. Therefore it is unlikely that he does a traditional DCF-model. But probably something that is quite similar, to complement the rest of his approach. Both Buffett and Graham have aired suspicion of too dogmatic computer models in the past. Buffett once stated, ”Beware of geek bearing formulas”, which gives a clue about his own approach.
Alice Schroeder, who wrote the book “Snowball“, about Buffet’s life, said that he used a very simple method, that was not based on rigid models when she studied him. But rather it seems to be based on historical records, intuition and stuff that he writes down on paper.
Buffet sticks to companies where the profits are stable and predictable. Because he wants to understand his investments completely. And stable companies are likely to keep being stable. Hence, they are more predictable and easier to understand. If it is a growing business he wants it to have high returns on capital. Otherwise, that growth is not worth as much. Because the company has to be able to reinvest those profits efficiently. Otherwise, those cash flows are best used elsewhere. In the case of See’s candy, it is an absolute cash machine. But the cash flows, from See’s Candy, are best used elsewhere, since the company is strong in a particular niche of the market. But does not easily scale and grow.
Margin of safety and beta
Buffett wants a margin of safety to calculate for the errors that he might commit in his investment thesis. But he does not believe in the concept of Beta. Which he talks about in the article ”The superinvestors of Graham and Doddesville”, from 1984:
“One quick example: The Washington Post Company in 1973 was selling for $80 million in the market. At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more. Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta would have been greater. And to people that think beta measures risk, the cheaper price would have made it look riskier. This is truly Alice in Wonderland.“
Obviously Buffett thinks Beta is nonsense when it is used for calculating risk. Which is what many other value investors thinks as well. One such value investor is Seth Klarman, who has contributed to the subject of margin of safety, in a book with the same name.
Seth Klarman’s Margin of safety
Seth Klarman is a value investor, billionaire and money manager of the Baupost Group. An Investment partnership founded in 1983. The fund manages around seven billions and has averaged returns of nearly 20 percent, since inception. Considering the size of funds under management and the length of that record, which is now close to 40 years, it is an impressive track record.
Klarman is closer to Benjamin Graham in his style. And closer to the style Buffett used in his youth, when he was buying ”cigarr butts”, many of which were Net nets. And he has written an obscure and elusive book, called Margin of safety. This book is hard to come by and as a consequence quite expensive. But it has gained almost a cult like following among value investors. And if you want to deepen your knowledge about the margin of safety-concept it is a well worth read.
Going back to Graham
The book describes the concept of a margin of safety as the separating factor between value investors and other investors. And Klarman believes that avoiding a big loss should be the primary goal for every investor. Seth Klarman believes that an investor is more likely to do well over time if they limit their downside. Perhaps the returns won’t be as spectacular but at least they will be sure and consistent. And compounding really works wonders over time, according to Klarman.
”It follows that value investors seek a margin of safety, allowing room for imprecision, bad luck, or analytical error in order to avoid sizable losses over time. A margin of safety is necessary because valuation is an imprecise art, the future is unpredictable, and investors are human and do make mistakes. It is adherence to the concept of a margin of safety that best distinguishes value investors from all others, who are not as concerned about loss.” – Seth Klarman, in Margin of Safety
Beta is not risk
Klarman’s book Margin of safety is filled with examples of how to invest in obscure and elusive parts of the market with a value mindset. For example junk bonds, bankrupt securities and spinoffs. Like Buffett, Klarman doesn’t think that Beta has anything to do with risk. But rather that risk is the price that you pay in relation to value. The margin of safety is there to eliminate risk as much as possible by limiting the downside. The margin of safety protects you against things that are out of your control. Because we can never know all the information about an investment.
Many analysts don’t calculate the margin of safety but only the growth estimations. So if you are new to investing it is even more important that you use a margin of safety to not incur a big loss. Personally I think it is best to use a variety of methods that you are comfortable with and understand. For example fundamental models, mental models, global macro analysis and sentiment.
Personally, I like to combine value investing with a number of other approches. For example technical analysis, global macro and sentiment. But the core of my investment style has always been value investing. And if you are going to learn value investing you need to understand the fundamentals. And the backbone of that should be an understanding of the margin of safety and intrinsic value concepts. Or as Buffett say:
“I have never been able to figure out why it’s riskier to buy $400 million worth of properties for $40 million than $80 million. There is essentially no risk in buying $400 million for $80 million, particularly if you do it by buying ten $40 million. You don’t try and 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. – Warren Buffett
Please discuss below how you calculate the margin of safety and the Intrinsic value, and what your view of Warren Buffett’s cash flow models are.
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