Always Invest with a Margin of Safety

Margin of safety is the principle of buying a security at a significant discount to its intrinsic value, which is thought to not only provide high-return opportunities, but also to minimize the downside risk of an investment. In simple terms, Graham’s goal was to buy assets worth $1 for $0.50. He did this very, very well.

To Graham, these business assets may have been valuable because of their stable earning power or simply because of their liquid cash value. It wasn’t uncommon, for example, for Graham to invest in stocks where the liquid assets on the balance sheet (net of all debt) were worth more than the total market cap of the company (also known as “net nets” to Graham followers). This means that Graham was effectively buying businesses for nothing. While he had a number of other strategies, this was the typical investment strategy for Graham. (For more on this strategy, read What Is Warren Buffett’s Investing Style?)

This concept is very important for investors to note, as value investing can provide substantial profits once the market inevitably re-evaluates the stock and ups its price to fair value. It also provides protection on the downside if things don’t work out as planned and the business falters. The safety net of buying an underlying business for much less than it is worth was the central theme of Graham’s success. When chosen carefully, Graham found that a further decline in these undervalued stocks occurred infrequently.

While many of Graham’s students succeeded using their own strategies, they all shared the main idea of the “margin of safety”.

Expect Volatility and Profit from It

Investing in stocks means dealing with volatility. Instead of running for the exits during times of market stress, the smart investor greets downturns as chances to find great investments. Graham illustrated this with the analogy of “Mr. Market”, the imaginary business partner of each and every investor. Mr. Market offers investors a daily price quote at which he would either buy an investor out or sell his share of the business. Sometimes, he will be excited about the prospects for the business and quote a high price. At other times, he is depressed about the business’s prospects and will quote a low price.

Because the stock market has these same emotions, the lesson here is that you shouldn’t let Mr. Market’s views dictate your own emotions, or worse, lead you in your investment decisions. Instead, you should form your own estimates of the business’s value based on a sound and rational examination of the facts. Furthermore, you should only buy when the price offered makes sense and sell when the price becomes too high. Put another way, the market will fluctuate – sometimes wildly – but rather than fearing volatility, use it to your advantage to get bargains in the market or to sell out when your holdings become way overvalued.

Here are two strategies that Graham suggested to help mitigate the negative effects of market volatility:

Dollar-Cost Averaging
Dollar-cost averaging is achieved by buying equal dollar amounts of investments at regular intervals. It takes advantage of dips in the price and means that an investor doesn’t have to be concerned about buying his or her entire position at the top of the market. Dollar-cost averaging is ideal for passive investors and alleviates them of the responsibility of choosing when and at what price to buy their positions. (For more, read DCA: It Gets You In At The Bottom and Dollar-Cost Averaging Pays.)

   Investing in Stocks and Bonds

Graham recommended distributing one’s portfolio evenly between stocks and bonds as a way to preserve capital in market downturns while still achieving growth of capital through bond income. Remember, Graham’s philosophy was, first and foremost, to preserve capital, and then to try to make it grow. He suggested having 25-75% of your investments in bonds, and varying this based on market conditions. This strategy had the added advantage of keeping investors from boredom, which leads to the temptation to participate in unprofitable trading (i.e. speculating). (To learn more, read The Importance Of Diversification.)

Know What Kind of Investor You Are

Graham advised that investors know their investment selves. To illustrate this, he made clear distinctions among various groups operating in the stock market.

Active Vs. Passive
Graham referred to active and passive investors as “enterprising investors” and “defensive investors”.

You only have two real choices: The first is to make a serious commitment in time and energy to become a good investor who equates the quality and amount of hands-on research with the expected return. If this isn’t your cup of tea, then be content to get a passive, and possibly lower, return but with much less time and work. Graham turned the academic notion of “risk = return” on its head. For him, “Work = Return”. The more work you put into your investments, the higher your return should be.

If you have neither the time nor the inclination to do quality research on your investments, then investing in an index is a good alternative. Graham said that the defensive investor could get an average return by simply buying the 30 stocks of the Dow Jones Industrial Average in equal amounts. Both Graham and Buffett said that getting even an average return – for example, equaling the return of the S&P 500 – is more of an accomplishment than it might seem. The fallacy that many people buy into, according to Graham, is that if it’s so easy to get an average return with little or no work (through indexing), then just a little more work should yield a slightly higher return. The reality is that most people who try this end up doing much worse than average.

In modern terms, the defensive investor would be an investor in index funds of both stocks and bonds. In essence, they own the entire market, benefiting from the areas that perform the best without trying to predict those areas ahead of time. In doing so, an investor is virtually guaranteed the market’s return and avoids doing worse than average by just letting the stock market’s overall results dictate long-term returns. According to Graham, beating the market is much easier said than done, and many investors still find they don’t beat the market. (To learn more, read Index Investing.)

Speculator Vs. Investor

Not all people in the stock market are investors. Graham believed that it was critical for people to determine whether they were investors or speculators. The difference is simple: an investor looks at a stock as part of a business and the stockholder as the owner of the business, while the speculator views himself as playing with expensive pieces of paper, with no intrinsic value. For the speculator, value is only determined by what someone will pay for the asset. To paraphrase Graham, there is intelligent speculating as well as intelligent investing – just be sure you understand which you are good at.

Most of us know who Warren Buffett is but all of us don’t know what his investment philosophy is. His investment philosophy has been seen as closely guarded secret and many people have been trying to decipher how the world’s greatest investor has been able to compound his investments for more than 20% annually for over 40 years.

Perhaps his philosophy is not so much so ‘guarded’ as it is fluid, being changeable most of the time to adapt to the evolving investment world. There are some core principles that he stands by in looking out for good investments which we all can learn from. Though the exact method in determining what is labeled as a good investment or not is not reveal, these core investment principles will allow us to follow Buffet to a certain extent on what he looks out for when buying a company.

Predictable Future Earnings

The key concept here is “the trend of increasing and stable earnings”. All past (and hopefully future) earnings ought to follow a straight upward pattern to warrant a consideration for investment. Such a trend indicates growth and sustainability of the company. Do note that the earnings trend is not affected by periods of recession, it is a great indication of the company’s ability to weather downturns and sustain its product line, hence generating returns for the investor. While the share price might drop due to downturns but in the face of increasing earnings, it ought to be seen as a good time to buy into the company. Key numerical indicators to follow are PE (price to earnings) ratio, PEG (price-to-earnings growth) ratio, adjusted profit and gross margins, and ROE (return on equity).

1. The key to investing is found in this rule: buy a share as though you were buying the whole company.

To do that, you have to know what the enterprise is worth. Therefore, the investor should live in the world of companies, never of mathematical formulae.

In the latest annual meeting of Berkshire Hathaway, Buffett’s company, his partner Charles Munger put it this way: “The worst decisions are often made with the most formal projections. They look so professional that you begin to believe the numbers are reality.

“You are taken in by the false precision. Business schools teach this stuff because they have to teach something.”

2. A recent heresy is that market volatility equals risk. Quite the contrary!

For a serious investor, volatility creates opportunity. To use my own language, investment opportunity consists of the difference between reality and perception. High volatility increases that difference, and thus increases opportunity for the knowledgeable investor.

Mr Buffett says sardonically that he favours the dotty “efficient market theory” because it creates more opportunities for him.

3. As to growth versus value, Mr Buffett observes that “value” should include projected growth, notably “growth at a reasonable price” or Garp.

He looks for companies with a business “moat” around them that should have steady, reasonably predictable growth.

Perhaps a better phraseology for the growth versus value dichotomy might be “high growth” versus “bargain hunting”. The analytical techniques, and investor temperaments, in the two approaches are quite different. One calls for a futurologist, the other for an accountant.

That said, for a taxpaying investor long-term growth is more convenient and more tax-efficient than seeking one bargain after another.

4. High technology, most emerging markets, leveraged buyouts, real estate and other hard to appraise exotica might as well not exist for Mr Buffett.

He follows the safest approach: stick to what you know best. However, many approaches are valid. Your advantage will be the extent to which your knowledge of a valid situation exceeds the market’s.

It makes little difference how broad your knowledge is. One correct investment decision is as valuable as another. Mr Buffett says that one should only seek a handful of really big ideas in one’s investing career. The key is to be right when you do decide, not to flutter about spreading yourself thin.

5. Investing in bad industries, or turnarounds, usually doesn’t work.

A skilled surgeon can excise a tumour but to revive a moribund patient requires a magician. The princess hopes that when she kisses the toad a beautiful prince will spring up. In fact, alas, she will probably end up awash in toads.

6. Businesses that generate cash that they can reinvest at high rates of return over long periods are particularly attractive holdings.

Low-margin businesses that periodically call for more cash from their investors, which they can only invest at a modest rate of return, are a dismal affair. Differently put, if all else is the same, feel free to marry an heiress rather than a pauper.

7. Don’t sell a great stock just because it has doubled.

It could be better value afterwards than it was before. The greatest stocks may go up 20 or even 100 times in a generation or two.

Peter Lynch, who built up Fidelity’s Magellan fund, points out that the deluded policy of “rebalancing” more or less automatically because a stock has risen is a lot like pulling out the flowers in the garden and watering the weeds. Don’t do it!

8. A grave corporate folly is offering your own underpriced stock for the fully valued stock of an acquisition candidate.

In that scenario, instead of paying 50p for £1 of value, you are paying £1 for 50p of value. Lunacy! Still, such situations are often generated by the megalomania of chief executives.

9. Avoid long-term bonds.

“We are bound to have inflation, given current policies. There are a lot of incentives for politicians in all countries to inflate their currencies,” Mr Buffett says.

10. To do superlatively well, an investor, like a company manager, must be a fanatic.

Excellent Business Economics

This is a very fuzzy concept that can be interpreted differently by different investors. Most cited examples are Coca Cola and Gillette to illustrate the point on excellent business economics. A business that has great business economics usually weather downturns well, is able to adjust to inflationary prices, almost a ‘necessity’ in daily living and a very strong branding. Warren focuses on ‘consumer monopoly stocks’ and not ‘commodity type’ business because of this. Earnings are a good indicator of the business economics of a business. For the average person like us, we just need to focus on business that are very visible to us and are on the growth path.

Don’t just buy shares, be a business owner

Buffett does most of his research on the company; it’s growth, management, and values more so than it’s financial statements. Some companies Buffett bought out he didn’t even do financial audits on simply because he trusted the business owner. Know the company you want to invest in well and know where they are going.