Summary and Discussion – Chapter 20 – ‘Margin of Safety’ as the Central Concept of Investment
Notes on The Intelligent Investor by Benjamin Graham
Notes by Jason Fernando
Created May 3rd, 2016
Last updated November 18th, 2017

Reference document: Graham, Benjamin, and Jason Zweig. The Intelligent Investor. Rev. ed. New York: HarperBusiness Essentials, 2003.

50-Word Recap

• Margin of safety is the most important concept in value investing.
• It refers to the practice of maintaining a sufficiently large gap between the price you pay for an investment and your conservative estimate of the value of that investment.
• This basic principle can be applied in many different contexts.

“…[T]o have a true investment there must be present a true margin of safety. And a true margin of safety is one that can be demonstrated by figures, by persuasive reasoning, and by reference to a body of actual experience.” [1]

“…[O]perations for profit should be based not on optimism but on arithmetic.” [2]

“You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right. Similarly, in the world of securities, courages becomes the supreme virtue after adequate knowledge and a tested judgment are at hand.” [3]

“Ultimately, financial risk resides not in what kinds of investments you have, but in what kind of investor you are. If you want to know what risk really is, go to the nearest bathroom and step up to the mirror.” —Jason Zweig [4]

If the title of his final chapter were not clear enough, Benjamin Graham starts its opening paragraph by referring to “margin of safety” as “the thread that runs through all the preceding discussion of investment policy.” [5] If you could only read one chapter of this book, let this be the one.

Let’s start with the most pressing question. What does “margin of safety” actually refer to? In essence, this concepts refers to the practice of ensuring that you leave yourself enough of a gap between a) the price you pay for an investment, and b) your assessment of what that investment is worth, so that, if you turn out to be wrong in your assessment, you are less likely to be significantly harmed.

For example, if an investor insists on investing with a 25% margin of safety, then she will pay no more than $75 for a share whose true value she estimates to be $100 (because $75 is 25% less than $100). What this means is that, even if she subsequently concluded that her $100 estimate was too high, she is less likely to be harmed because she already gave herself some slack (or “wiggle room”) by buying with a margin of safety.

To clarify, this estimate of $100 refers to what the investor thinks the investment is worth, based on her detailed and careful analysis. In other words, it refers to the investment’s intrinsic value, as opposed to its market value (the latter of which is simply the price at which most buyers/sellers are willing to buy/sell). It is quite possible—and indeed rather common—for value investors’ estimates of intrinsic value to be significantly at odds with the actual market prices of those companies at the time in which their analysis is made. Consequently, value investors sometimes wait months or even years before being able to make their investments at a price that is sufficiently below their intrinsic value to meet the investor’s minimum desired margin of safety.

Incidentally, this last point helps explain why—if you’ll excuse the blatant generalization—value investors tend to be most comfortable away from the hustle and bustle of Wall Street and the other financial centers. Because intrinsic values are often quite at odds with market values, there is not much point in paying close attention to what the majority of investors are doing. Instead, most value investors are content to monitor their shortlists of promising investments, pouncing on such opportunities when they finally do arrive, and spending the rest of their time continuously researching current or future investments. The mainstream financial press and the constant torrent of moment-to-moment financial information is, for the most part, an irrelevant if impressive distraction. [6]

But let’s get back to the topic at hand. In addition to the example cited above (buying a company’s shares only when they are 25% below your assessment of their intrinsic value), the concept of margin of safety also enters into the investment decision-making process in other, subtler areas. For instance, Graham cites the example of only investing in the shares of railroad companies whose pre-tax income is at least five times their total annual interest expense. [7] In this instance, we are giving ourselves a margin of safety against the risk that the company might become unable to pay the interest on its debts. The key takeaway from this chapter is to understand the underlying principle of margin of safety, so that you can learn to apply in all sorts of different contexts—perhaps even extending it into situations and applications that Graham had never imagined.

One of the ways that Graham communicates the principle of margin of safety is by describing it as a protective measure against our inability to accurately forecast the future. If we were able to accurately estimate future events, such as the precise trajectory of a company’s future earnings, then there would be no need to protect ourselves against uncertainty by insisting on buying with a margin of safety. If we could accurately project a company’s future revenues and interest expenses, without risk of errors in judgment or significant unforeseen events, then insisting that companies earn five times their interest expense would be superfluous. But history has shown repeatedly that humans’ capacity for accurately forecasting events is exceedingly poor. Margin of safety, then, is a protection against ourselves. As Graham put it, “the function of margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future.” [8]

Another way to think about margin of safety is by comparing the “earning power” of a company to the interest that one could receive from a comparable bond. In this context, “earning power” refers to the company’s profit-generating capacity. As Jason Zweig notes on pages 513 and 514, a convenient way of interpreting “earning power” is as a synonym for “earnings yield”, where earnings yield is defined simply as the reverse of the price-to-earnings ratio (or, in other words, as the company’s earnings per share divided by its share price). By this interpretation, a company with an earnings yield of 10% would offer a 50% margin of safety as compared to a bond that pays 5% interest. If the company’s earnings yield were 8%, then its margin of safety would be 37.5%. Lastly, if there is no difference between the earnings yield and the interest rate, then the company’s margin of safety would be 0%. For further discussion on this point, see Zweig’s footnote to pages 515-516.

Suppose you buy shares in a company with an earnings yield of 10%, at a time when a comparable bond would pay 5% in interest. For the sake of simplicity, let’s further assume that the earnings yield and the bond interest rate both remain constant for the next 5 years. In this scenario, some or all of the 10% earnings yield generated by the company would be reinvested in its own business operations, year after year (if the company pays dividends, then some of those earnings would be paid out directly to you, with the remainder being reinvested in the business). By repeatedly reinvesting its earnings in this manner, the value of the business’s shares is likely to rise over time to reflect the build-up in assets owned by the business—at least over the long term.

You might be wondering why it is that the shares are likely to rise in value. After all, there’s no natural law forcing investors to “bid up” the price of companies who repeatedly reinvest earnings. Although it’s true that there is no guarantee that such price increases will occur, under normal market conditions such rises are indeed common. To understand why, consider a simple scenario in which a business generates a 10% earnings yield per year and simply holds that generated cash on its balance sheet. Year after year, the company’s cash holdings grow as it continues to add more earnings. In this scenario, it is easy to understand why the market price of that company would rise: by buying its shares, you are taking ownership of a larger and larger pool of assets.

The same logic applies in the event that the company invests its earnings rather than simply holding them in cash. For example, if the company invests those earnings in new inventory, technology, or other such productive assets, then it is reasonable to assume that those investments will increase the value of the company. This value would most likely be reflected in an increased share price—again, at least over the long term. In Graham’s words: “…if the picture is viewed as a whole, there is a reasonably close connection between the growth of corporate surpluses through reinvested earnings and the growth of corporate values.” [9]

If the above examples made matters less clear rather than more so, simply remember that, at the end of the day, “The margin of safety is always dependent on the price paid.” [10] All else being equal, the smaller the price you pay for an investment, the larger the margin of safety you will receive. Of course, the art and challenge of value investing arises from the fact that, in the real world, all else is never quite equal! Most of the time, cheaply-priced businesses are priced cheaply for good reasons, and it’s seldom profitable to invest in poor-quality business simply because they are cheap. [11]

This is especially true in circumstances where overall price levels in the stock market are very high. In these optimistic times, investors tend to be far less scrupulous when it comes to insisting on high-quality investments. In a way, this tendency is quite understandable. After all, in boom times it truly does seem as though anything one could buy would rise in value. Why spend dozens of hours analyzing investments when practically any choice you make seems destined for success? The answer, of course, is that it is precisely in those moments of heightened optimism where thorough analysis matters most. All else being equal, the higher the price you pay for an investment, the lower the margin of safety you receive. Another way of phrasing this axiom is that, all else being equal, higher price equals higher risk.

In light of these principles, how can we protect ourselves against the risk of paying too high a price? One simple answer is that, when evaluating a company’s profitability, we can always consider as much historical information as possible. For example, if a company reports very impressive profits in the current year, it is prudent to research its profitability in past years in order to come up with a more grounded and realistic estimation of what its profits are likely to be in the future. By doing so, we help protect ourselves against being overly swayed by recent profits that might have been the result of unsustainable and abnormal factors. As Graham notes, failure to do so is both a typical and costly mistake made by investors:

“Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions. The purchasers view the current good earnings as equivalent to “earning power” and [falsely] assume that prosperity is synonymous with safety.” [12]

What Graham is basically saying here is that:

1. It is not enough for a business to simply show impressive earnings in a given year. What we should be looking for are businesses with a track-record of consistently good results over many years—the more than better. [13]
2. Always remember that “earning power” can only be judged based on a very long history of earnings. A company’s current earnings are not the same as that company’s earning power. Coming up with an estimate of earning power requires us to delve into the company’s past, i.e. by taking the average of its last 10 years of earnings.

So, so far we have talked about “margin of safety” in three different ways. We have defined it as:

1. The difference between the price paid for an investment and the perceived intrinsic value of that investment (i.e., if we purchase an investment for $50 when we perceive its true value to be $100, we would have obtained a margin of safety of 50%).
2. The difference between the earning power of an investment and the interest rate paid on a comparable bond (i.e., we purchase an investment with an earning power equivalent to a 10% annual return, at a time when comparable bonds offered 5% interest, and thereby obtain a margin of safety of 50%).
3. The degree to which a company can “cover” (meaning, pay for) financial obligations such as interest payments. I.e., a company whose pre-tax income amounts to five times its annual interest expense has a larger margin of safety (with respect to interest payments) than a company whose pre-tax income amounted to two times its annual interest.

In all cases, the intuition is clear: Focus on mitigating the two main risks of investing—one, the risk of buying an inferior business; and two, the risk of paying too much for its shares. If you do this consistently and over long timespans, the rewards of investing tend to take care of themselves! Or, put another way, focus on covering your risk of loss, and your risk of reward will look after itself.

Footnotes

[1]  Graham, Benjamin, and Jason Zweig. The Intelligent Investor. Rev. ed. New York: HarperBusiness Essentials, 2003. Page 520.
[2] Ibid., 523.
[3] Ibid., 524.
[4] Ibid., 528.
[5] Ibid., 512.
[6] Of course, one could argue that this quaint conception of the value investor is mostly just a mirage. In reality, many value investors are embedded within the mainstream financial community. Nonetheless, the image of Warren Buffett running Berkshire Hathaway from the relative isolation of Omaha, Nebraska has had an enduring charm and influence over how many value investors like to think of themselves—myself included!
[7] Ibid., 512.
[8] Ibid., 513.
[9] Ibid., 514-515.
[10] Ibid., 517.
[11] There are of course exceptions to this rule. Some companies are priced so cheap as to make them “more valuable dead than alive”. For example, consider the case of a company whose market value is less than the cash in its bank accounts after deducting all its liabilities. Theoretically, investors in such a company could realize a profit even if the company enters bankruptcy! In scenarios such as this, it is very likely that the company in question is experiencing severe stresses on its business (otherwise, why would its price be so low?) Yet there is a point beyond which even inferior companies start to look underpriced. Some investors, including Graham, have had great success by investing in these kinds of bargain-basement companies. Still, though, these scenarios are the exception and not the rule. For the most part, it is prudent to steer clear of low-quality businesses.
[12] Ibid., 516.
[13] I personally consider the last 10 years of earnings, although admittedly Graham would probably view this as too short a memory span. Most investors these days would focus on the next quarter’s estimated earnings when considering the value of a business today! The gap in historical perspective between Graham’s style and the prevailing norms of today could hardly be wider.