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…
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.
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:
- Discounted Cash Flow (Investopedia)
- DQYDJ.com’s Discounted Cash Flow Calculator
- Guru Focus’s Discounted Cash Flow Calculator
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.
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.
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?