Matt Franz : Zealous For Knowledge

Margin Of Safety

Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.

– Ben Graham, The Intelligent Investor

The concept of margin of safety is one of (if not the most) powerful idea in all of security analysis. When you have a wide margin of safety, a detailed forecast of the future becomes unnecessary because your investment can handle the broad spectrum of possible outcomes. This is good news, considering how hard it is to forecast the future.

Ben Graham also wrote in The Intelligent Investor:

The margin of safety is always dependent on the price paid. It will be large at one price, small at some higher price, and nonexistent at some still higher price.

Here’s an example. Let’s say you and a friend are going to flip a coin 1,000 times. Each time it turns up heads, you get $1.00. How attractive this game is to play depends on what you must pay to play it.

If you pay $10 ($0.01/flip), it is a great deal. You have a large margin of safety. If you win 50% of the flips you will net $490. You have ample room for a run of bad luck and randomness in the outcome to prevent losing money.

If you pay $1,000 it’s a mediocre to poor deal. You’re unlikely to lose much money, but you’re not likely to make anything either. It’s a waste of time and you should skip it and move on. There is no margin of safety at this price.

If you pay $2,000 its a terrible deal. You’re likely to lose $1,500 net playing it this way. You might do slightly better or slightly worse, but the net result will be almost assuredly bad.

As you can see, the attractiveness of the game and your likelihood of loss is totally dependent on the price paid. This is good news because the price you pay is just about the only variable that is 100% in your control as an investor. The lower price you pay, the greater your margin of safety, without exception.

That doesn’t mean you can’t find a margin of safety in something beside price. Nor does it mean that anything with a low price is a good investment. All it means is that you will never go wrong preferring low prices to high. Low prices leave a lot of room for bad luck whereas high prices leave little. It’s much better to rely on a low purchase price than an accurate forecast in an uncertain, constantly changing world.

Brent Beshore recently wrote about a dinner he had with Buffett and Munger. I think they sum it up best:

Many of my questions centered on Berkshire’s due diligence process, which is notoriously simple. I questioned whether the public story matched private practice. After patiently answering a series of specific questions about his acquisitions through the years, he [Buffett] said, “Price is my due diligence.” It was a show stopper and a clear articulation of his philosophy. The lower the price, the less due diligence required. If you pay a good enough price, a lot can go wrong and still be right.

Questions or comments? Email matt@eaglepointcap.com

This is not a recommendation to buy or sell any stock mentioned. I do not have a position in any stock mentioned unless otherwise noted in this post. Do your own research: you are accountable for your own returns. Please read my full disclosure



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