Your Margin of Safety Has Gone Missing


The wind whips through your hair as you peer out the doorway.  Your feet are mere centimeters from the edge, and your hand is gripping the doorway like a vice.  The ground passes-by thousands of feet below the plane, and there’s nothing between you and a very solid ground.

You feel it in your stomach — that incredibly large pit is fear.

Fear is natural.  You’re going to jump from a plane.  Under normal circumstances most people would only do so wearing a parachute … or with the possibility of some kind of safety net or padding below.

Instead, your going jump without the benefit of a parachute or other safety measures.  Your only hope is that you can spread your arms and soar like a bird…

Stupid, right?

Such a scenario sounds so incredibly dumb you’d never dream of doing it.  It would probably end your life.  Yet, that’s exactly what millions of investors do every day when they invest in the stock market.

They’re jumping-in without the benefit of a parachute or any kind of safety gear in place… and they’re doing it without the fear nature provides us in life or death situations.

Except in the case of the stock market, it’s your financial life at stake.

 

Margin of Safety

After losing most of his portfolio in the 1929 crash (and subsequent depression), Professor Ben Graham decided that if he was going to invest again, he’d be doing so with a margin of safety.

Ben Graham was the father of value investing and wrote several profoundly important books on investing.  (If you haven’t read The Intelligent Investor yet, you should just drop everything and go read it.)

In his writing, Graham called for fellow investors to invest only when they had a significant margin of safety — a investing “parachute” of sorts that would protect the investor from falling stock prices.

But what exactly is margin of safety, and how does an investor get it?

Quite simply, margin of safety is the difference between the price you pay and the intrinsic value of the asset.

To have a margin of safety, the intrinsic value of the stock must be larger than the price paid.

When Warren Buffett talks about this margin of safety, he often talks about driving a 10,000 pound truck over a bridge.  If you were the truck driver, you’d never want to drive that truck over a bridge rated for 9,800 pounds.  Instead of risking it all, you’d probably drive a little further and find a bridge rated for 20,000 pounds instead.

old bridge
What’s the intrinsic value of your bridge?

That extra room for error is your “margin of safety”, and the bridge rating is your “intrinsic value”.

 

Calculating Intrinsic Value

Before we can determine our margin of safety, we first have to calculate intrinsic value.  Easy, right?  It’s easier said than done.

In the old days, Graham and Buffett would have used book value to determine the intrinsic value of an asset (plus or minus some amount to deal with “suspect” assets or hard to liquidate assets).  I’ve written about book value investing before — in modern times these techniques are less likely to be useful.

Now, modern companies have fewer physical assets to liquidate.  Businesses are different now — They outsource the production of physical products to Asia.  They don’t hold nearly as many physical assets.  Many hold patents and intangible assets instead.

Since businesses are different, that means different methods must be used to value them.  These days the most common method is by calculating Discounted Cash Flow (DCF).

Rather than bore you with a stuffy explanation of the all the math involved, I’ll just point you toward some good links and good calculators to help you calculate it on you own:

Let’s be clear though — DCF is a powerful tool, but it’s far from perfect.  There are many guesses required to calculate DCF.  It’s easy to make mistakes.  Unless you know a stock extremely well, your estimates of growth and future business prospects will be guesses.  Even tiny mistakes can drastically change a computed DCF value!

But guesses can be OK if your margin of safety is large enough.

 

Durable Competitive Advantage

Finding the present value of future cash flows via DCF analysis isn’t the end of finding intrinsic value however; it’s only the beginning.

No matter what growth values you plug into the DCF calculation, if the company can’t survive against ruthless competitors or the next recession, then you’re shit-out-of-luck.

What we need is a durable competitive advantage.  What’s durable competitive advantage you ask?

A durable competitive advantage is a special business attribute that allows a company to survive or thrive even under adverse conditions.  These kinds of advantages rarely show up on a balance sheet or cash flow statement — but they do exist.

These durable competitive advantages (sometimes called “moats”) fall under a few main categories:

  • Brand  — A brand is more than just a name.  A brand is a feeling of trust associated with a brand-name that customers will gladly pay more for.  Coke is probably the most famous global brand with durable competitive advantage.  Rather than pay less for an unknown brand, most consumers will simple pay a few pennies more to buy Coke (a brand they trust) rather than a unknown brand
  • Patents, Contracts, Licenses and Secrets (intangible assets) — Patents, contracts, licenses, and secrets are all forms of intangible assets that can be used to protect against external competition.  In the case of patents, companies use these intangible assets to legally protect against another company copying their product (at least until the patent runs out).
  • Switching Costs  — Switching costs are an advantage that keeps customers from leaving.  For example, closing a bank account — many banks will charge you money to close that account!  That’s a switching cost!  Switching costs can also be non-monetary too  — If you’re attempting to switch from an Apple phone to a Android phone, it will require a certain amount of “re-learning” of phone functions to be productive.  Apps will also need to be re-purchased, and photos moved.  This is a switching cost because it deters people from change.
  • Network Effects  — Network effects are a form of competitive advantage that’s derived from a network of customers (or suppliers).  The larger the network, the more value it contains.  Think of Facebook or Twitter.  If only a few people use those services, then you wouldn’t have a problem switching to another service.  However, if A LOT of people are using Twitter, the value of those services is suddenly much higher.  You’re far less likely to leave if the network is larger.
  • Low Cost Leader — Being a low cost leader has significant advantages in industries where price matters.  If a company is able to produce a product or service far cheaper than all the rest of the competition, then it’s said this company is a “Low cost Leader”.  This is an incredible advantage when customers are price sensitive (like airlines or groceries).
  • Industry Structure  — Industry structure can also play a large part in the durability of a business.  How many competitors are there?  Are the competitors global or regional?  Imagine a company with no regional competitors.  Perhaps that region can only support one company due to its size.  That company is far more likely to survive being the only game in town.
  • Barriers to Entry — Barriers to entry make it difficult for new competitors to enter a business.  Typically these barriers consist of high startup costs, government regulation, or “special access” to unique resources.  Potential competitors would find entering that business extremely difficult, and thus be deterred from entering the business.

These special non-monetary attributes make an investment more durable to competition or economic declines.  In most situations, that means your estimates of intrinsic value can be bumped a little higher.

(This is the part where investing becomes more art than science)

Today I’ve only touched the surface of durable competitive advantages.  A simple google search can provide tons more information and great examples of durable competitive advantage.

Fantastic, right?  Every investor wants to own that special investment that keeps on truckin through a recession…

Except that nobody’s trying to calculate intrinsic value!

 

Where’s Your Parachute?

If you’re like most people, you invest a small chunk of your paycheck every month and it gets deposited into your 401k.  From there, that money is typically invested in low cost index funds…. and you simply move on with life, waiting for markets to carry the value higher.

While there are many positives to this style of investing, there’s also a few negatives.  The most relevant (related to margin of safety), is that you’re piling money into the market at any price.  The price you invest could be above or below the intrinsic value.  Nobody bothers to even look!

This is the biggest problem (in my opinion) with investing in a broad market index fund.  If you’re putting money in at high prices then you’re buying into the froth on top.  Well above most estimates of intrinsic value.

froth
How much of current market prices are froth and how much are substance?

Some day a recession is going to come along and blow-off that froth.  The only thing to support asset prices will be intrinsic value and your margin of safety.

Proponents of the “index-at-any-price” investing style assert, “It’ll come back again!  Just hold on.  The market always goes up”.

Does it really?  Ben Graham might have something to say about that.

Let’s do a little reality check here — As I discussed in my previous post, research has shown that many stock markets around the world have experienced long-term returns that were actually negative.  Those numbers aren’t made-up.  That’s real.

How does it happen?

Japan’s stock market provides a very instructive example —  During the 80’s the Japanese economy was on top of the world.  They were experiencing incredible economic growth.  Things were going absolutely gangbusters in Nippon…

Until the bubble finally popped in 1991-92.  All that market “froth” finally got blown-off of asset prices.  Stocks tumbled (along with real estate prices) and have never again regained those inflated prices.

It’s been over 25 years and prices still haven’t come back. 

nikkei stock market
The Japanese stock market experience over the last 25 years.  This would kill most early retirement plans.   Image Credit: Yahoo Finance

Investors that put money into the market nine years after the crash would have done OK.  I argue that this is because they were purchasing much closer to the market’s intrinsic value (or possibly below it).  Due to the higher margin of safety those investors were more likely to realize decent returns.

This is hardly a consolation for anyone who retired at the 1991 peak.  They would still be waiting for the market to “come back” if they followed the advice typical in our market today.

(Note: Even the U.S. stock market has see extended periods of non-performance — From 1920 to 1942 and from 1965 to mid 1982. )

 

Where’s Your Fear?

I know this post won’t sit well with many investors that have done exceptionally well in the U.S. market over the last decade.  I get that they’ve done well.  I have too.

But I also think they could be a little arrogant.

Many investors will probably scoff at this post and say, “Who needs to calculate a margin of safety?  I’ve done just fine dumping my money into the market at any price!  If the market goes down, it’ll come right back up in a year or two!”

Fear of loss is completely absent from the thoughts of the average investor right now.  I see only greed in those eyes.

Who need a parachute when you can fly.  Right?

 

[Image Credit: Flickr1, Flickr2, Flickr3]

33 thoughts on “Your Margin of Safety Has Gone Missing

  • April 14, 2018 at 4:48 AM
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    I think you misunderstand many of us who like indexing. It’s not arrogance, it’s mistrust in the ability to foresee the future and inability to comprehend how to calculate the margin of safety.

    It’s not hubris. It’s making the best decision we can, given our knowledge, and our inability to know what comes next.

    It’s just as possible that one will miss out by sitting out too long than will gain.

    Recent history favors the indexer. God knows about the future!

    You also are a heck of a lot smarter and more studied than most hobbyists. Hell, than most professionals.

    I suspect if we take a bath like Japan, savvy and unsavvy will suffer similarly.

    Thank you for this perspective! I have no immediate argument to contradict it.

    Reply
    • April 16, 2018 at 9:08 AM
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      To be clear — I also own some index funds, but I’m very careful about the price I pay! 🙂

      Reply
  • April 14, 2018 at 6:08 AM
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    You could be exactly right about the U.S. although I would argue, as Warren Buffett has repeatedly said, we here in the U.S. have the best system in place for capitalism to thrive and so our markets have done better over time. Of course nobody really knows if this will last.

    I have been thinking for the last few years that Japan may be where we should be investing more of our hard earned dollars. A lot of people argue with me on this but it’s been more than a generation since their property and market bubbles have popped and the new crop of young investors don’t remember the pain involved before. The excesses have been rung out and it’s time to ramp up again. The next run for Japan could be spectacular again. Just my thoughts…

    Reply
    • April 16, 2018 at 9:10 AM
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      I know several other bloggers who’ve invested in Japanese net-nets and they’ve done pretty well. There *are* quite a few cheap stocks there.

      However, I’ve also visited the country and I’m a little less enthusiastic about investing there because of some of the things I’ve seen.

      Reply
  • April 14, 2018 at 6:38 AM
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    Mr. Tako – Great post and I particularly liked the info on Durable Competitive Advantage AKA moats.

    “Who needs to calculate a margin of safety? I’ve done just fine dumping my money into the market at any price! If the market goes down, it’ll come right back up in a year or two!”

    I agree that the US market is very frothy and has been for some time. I’ve been expecting a major bear market for several years and still expect one any day now. So I think I get the need for some kind of margin of safety.

    For me, the margin of safety comes from diversification into bond, REIT, international stock, and US stock low-cost mutual funds. I rebalance my portfolio every year so as the US market goes up, I’m selling US index funds to buy other types of funds. Does that make sense as a margin of safety? I hope so.

    Of course, if everything goes down at once, I’m screwed, but short of shorting 🙂 , I’m not sure how to deal with that other than keep funds that I need in the near-term in bank accounts.
    Mr. Freaky Frugal recently posted…Right investing effort

    Reply
    • April 16, 2018 at 9:13 AM
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      Actually diversification is a little different than margin of safety.

      Imagine you had a bunch of kids — you put each of them into seperate cars but didn’t bother to buckle them in. That’s diversification. One car might crash, but the other kids in the other cars might survive.

      Margin of safety is essentially buckling that safety belt.

      See the difference?

      Reply
  • April 14, 2018 at 7:09 AM
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    Jumping out of an airplane with no parachute – no one will survive, can’t be done (at altitude of course)
    Investing in the US Stock market – millions have gotten rich and gotten out. Millions of others have made tons of money

    Not quite the same, but I see the metaphor you are shooting for. In both scenarios, there’s blind faith involved. But in one there’s no precedence for survival, while the other has a long track record of success.

    Of course, past success does not guarantee future success – I get it 🙂

    I’m not sure being in index funds and having “faith” or “hope” they’ll continue to go up is arrogance. I consider it having faith and hope, plain and simple. At any second the Earth can get hit by a huge asteroid that will kill us all. Does that mean that making vacation plans for next weekend is arrogant or having blind faith? It means that I just have faith and hope that the planet will not get hit bay an asteroid, like it usually doesn’t.

    But anyone who reads a basic science book KNOWS that the Earth WILL get hit by a big asteroid in the future. When? Who knows. Just as we all know the stock market will come screaming back down.

    Bottom line – you take your own chances.

    My margin of safety is bonds, REITs, and some cash, but in a Japan-like scenario I think most things besides cash would kind of screw you anyway. That’s just a difficult scenario to win in.

    Thought provoking post, kudos!

    Reply
    • April 16, 2018 at 9:18 AM
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      I wasn’t expecting you to be one of the detractors Accidental FIRE, but that’s OK. I kind of expected to get a few.

      My post was mainly about safety systems. We do almost everything with safety systems *except* invest. Seems like a problem to me.

      Reply
      • April 16, 2018 at 9:55 AM
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        Oh I’m not disagreeing with you at all, I just think it comes down to taking a risk that one is comfortable with. So for a younger person (say in their 20’s), they might be 100% in stocks and their safety system is time. Actually I think time is the safety system for many folks. They think “if it crashes it will recover, and I’ll still be young”.

        It’s all risk in the end. Your post did me a service in reminding me that I probably should start to build a few more safety systems in my plan. Whether that’s more cash or REITs or something else. But in reality I’m pretty conservative, which is why I stay part-time employed 🙂

        Reply
  • April 14, 2018 at 8:23 AM
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    I have done well in the U.S. market, but I’m still cautious with how I invest and this has come from both gains and losses. I agree with you. There are many people who are risk takers, but they forget to thoroughly process everything and this can lead to huge losses if you’re not careful. I might not gain as much as some investors, but at least I have peace of mind. Thank you for your insight. Great job at growing awareness on this growing trend.
    Fritz Chery recently posted…Allstate Vs State Farm

    Reply
  • April 14, 2018 at 8:33 AM
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    I agree with your thesis. The Shiller PE 10 suggests the next 10 years of returns will be very modest with the only returns coming from dividends with principal likely not keeping up with inflation.

    I am a big advocate of keeping a higher personal margin of safety by continuing to work (I found another executive job that will move and my family to the UAE for a spell) and create a large gap between passive income coming in and expenses.

    Perhaps it’s over the top in cautiousness but I think it’s a sound strategy at age 44.

    If you are not early retired and still have plenty of cash flow a stagnant and declining market over a decade can be a huge friend in the decades that follow.

    But you are absolutely correct- the companies in the portfolio need to have a durable competitive advantage. That, plus buying at an attractive entry valuation, will usual take you far.

    -Mike
    -Mike

    Reply
  • April 14, 2018 at 11:05 AM
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    I seem to always remember useless facts but when I read this excellent post my mind kept going back to reading about a guy in world war II who jumped out of his burning airplane without a parachute and fell thousands of feet and survived without major injuries. So I looked it up and amazingly five people in the history of flight have free fallen without a parachute from airplanes at heights of 10,000 feet to 33,000 feet and survived the impact largely intact. The altitude record is held by Vesna Vulovic who was a flight attendant whose airliner was destroyed at 33,000 feet altitude by a briefcase bomb in 1972. She made a full recovery and only died two years ago. That is a fall of over 6 miles!

    Reply
    • April 16, 2018 at 9:22 AM
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      Yes, I’ve read those survivor accounts too. Those people are damn lucky, that’s all I think we need to say about that. 🙂

      Reply
  • April 14, 2018 at 12:29 PM
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    In 1996 Greenspan have his irrational exhuberance speech some feel based on Schiller using the term earlier this year. CAPE was higher then it is now. Pop quiz did the dot com crash ever drop below this point? Answer no. Did it eventually have a crash? Yes. There’s a lesson there, that over priced is truest only something you can tell in hindsight.
    FullTimeFinance recently posted…Churning Strategies: What Card?

    Reply
    • April 16, 2018 at 9:24 AM
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      I actually disagree that you can only tell in hindsight. I easily avoided most bad investments during the 2008/2009 Great Recession because *I could* tell.

      Reply
  • April 14, 2018 at 1:26 PM
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    even though I’m not into individual stocks I believe the margin of safety concept needs to be applied into most areas of life. such as not arriving at the dentist with 30 seconds to spare, or not retiring the moment you hit 4% SWR on a starving student’s budget…

    enjoy your investment posts… thks mr tako

    Reply
    • April 16, 2018 at 9:26 AM
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      That’s diversification — it’s actually a different concept than margin of safety (see my earlier comments to another commenter).

      They both do something different for a portfolio.

      Reply
  • April 15, 2018 at 12:02 PM
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    You’re always so in-tune with me, Mr. Tako! Funny enough, I’m currently reading “The Intelligent Investor” (I’m about 20% in). Very good so far even though there are parts of it that are way over my head.

    As I’m getting closer to pulling the ripcord on my own FIRE parachute in a little over a year and a half, my investment strategy is making me nervous. A bull market tends to make folks think that the good times will never end. But when it does, look out! You’re Japanese stock market example makes me want to throw up with fear.

    I’m one of those guys you mentioned who takes a portion of my paycheck every two weeks and invests in low cost index funds. While I think it’s actually a good strategy for the long-term, it could be a rocky road when zooming in over a few-year period.

    For me, I’ll likely still continue on that path until I quit my job soon. However, in the meantime, I try to diversify in other things to try to smooth things out in case of rough times. For example, having the income from our rental properties and side businesses help us to be less reliant on a consistently strong stock market.

    — Jim
    Jim @ Route To Retire recently posted…Guest Appearance on the Retire Hoppy Podcast

    Reply
    • April 16, 2018 at 9:29 AM
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      That’s a smart strategy Jim. Indexing has worked really well this last decade, but it’s also made many investors ignorant to the price they’re paying.

      So many people are doing this, it’s made the US the most expensive market in the world.

      Reply
  • April 15, 2018 at 9:52 PM
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    Thought provoking, as often, Tako san.

    As others have mentioned, everyone has their ways to bring some safety to their investments. I like Doc G’s reply. IMO people doing index investing are no more arrogant than others in average, we just accept that we can’t predict much, and will sit on the side of history/statistics.

    Reply
    • April 16, 2018 at 9:34 AM
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      I can’t predict what will happen either, but you don’t drive a car or jump out of a plan without safety systems in place.

      Why do we invest without a safety system? Think about it!

      History/statistics actually are not on the side of ‘go-go’ stock investors. As I noted in the post there have been multiple periods (even in the USA) where the market has been stagnant or down for nearly 20 years.

      Anyone who wants to retire with significant funds in the market needs to know this can and will happen. Can you live for 20 years without stock appreciation?

      Reply
  • April 16, 2018 at 3:56 AM
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    Very nice post Mr Tako. I never though of the margin of safety like this. It’s really interesting. Even for me, a passive investor, this is helping. I think that a global diversification is still the way to go. But as you mentioned, markets don’t always go back up.
    The Poor Swiss recently posted…First six months of blogging – Lessons learned

    Reply
  • April 16, 2018 at 7:17 AM
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    Nice post Tako

    The current japanese market is basically a worst case scenario since I dont think any market has been like that. That would be devasting to say the least.

    Of course its a good idea to look at worst case scenario though!

    I agree with the index investing scenario. While your buying the whole market you are also buying all these fang stocks that have insane multiples and seem overvalued to say the least.

    Id rather find the solid dividend companies at a decent valuation or undervalued like you mention. Recently i have been focusing on higher moat companies.

    Keep up the great posts.
    Cheers

    Reply
    • April 16, 2018 at 9:35 AM
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      I don’t have the numbers in front of me, but Argentina might actually be a worse situation than Japan. I really need to research that one more.

      At any rate, I think you’ll do pretty well staying away from the FANG stocks and focusing on more ‘affordable’ moat companies.

      Good luck!

      Reply
  • April 16, 2018 at 5:21 PM
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    I think Japan is a good and bad example at the same time. Good because it should remind people that shit can always happen. Bad because US is still the world’s biggest and most open economy. Back in the 80s when you invested in Japanese stocks, you invested in the Japanese economy. But now when you invest in US stocks, a big part of your money is invested in global economy.
    I live in the Netherlands, but most of the products I purchase are connected in some ways to US listed companies. I can see Japanese, Chinese, European etc. companies being listed in the US, but until I see future Apples, Amazons, Microsofts considering their primary listings outside the states, I wouldn’t be worried about American index funds.
    Roadrunner recently posted…March 2018 – Financial Overview

    Reply
  • April 16, 2018 at 7:05 PM
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    Ok so what should your safety margin be?
    If for 20yrs no returns In The market then how much do I need and where should I keep it?

    Reply
  • April 17, 2018 at 8:12 AM
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    So if the majority of your wealth is in index funds at these PEs, it might be worth taking some money off the table and recycling it into some more ‘value’ stocks?

    Reply
  • April 17, 2018 at 10:01 AM
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    I agree that US stocks are overvalued. But if you are maxing out your 401k plan and the only options are to invest in stocks (index funds) or bonds, what would you do? Interest rates on bonds are going up so it decreasing the value on older bonds.

    Seems like you can’t win in the short term.

    Reply

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