Margin of Safety in Value Investing

Warren Buffett, his mentor Benjamin Graham, and multiple other famous investors say that the key to successful investment is not risking one's principal.

Descriptions

Benjamin Graham

Graham wrote in The Intelligent Investor:

"In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, "This too will pass." Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto - Margin of Safety."

Benjamin Graham, Chapter 20: “Margin of Safety” as the Central Concept of Investment, The Intelligent Investor.

Warren Buffett

Warren Buffett — Graham's most famous pupil — simply states the same rule as:

"Rule #1: Never lose money. Rule #2: Never forget rule #1."

Warren Buffett, Adam Smith’s Money World: How to Pick Stocks & Get Rich, PBS (1985).

Seth Klarman

Billionaire Value Investor and hedge fund manager, Seth Klarman, too says:

"Loss avoidance must be the cornerstone of your investment philosophy."

Seth Klarman, Margin of Safety: Risk-averse Value Investing Strategies for the Thoughtful Investor.

Peter Thiel

Peter Thiel, co-founder of PayPal and the first investor in Facebook, writes in his book Zero to One:

“First, only invest in companies that have the potential to return the value of the entire fund. This is a scary rule, because it eliminates the vast majority of possible investments. (Even quite successful companies usually succeed on a more humble scale.) This leads to rule number two: because rule number one is so restrictive, there can’t be any other rules.”

Peter Thiel, Zero to One: Notes on Startups, or How to Build the Future.

Do note that Thiel was referring to the highly focused nature of Venture Capital funds here. Thiel talks about only picking companies that can each repay the entire fund, and is more related to the counterintuitive Value Investing principles of diversification.

However, on a broader level, what Thiel is saying is also an application of the Margin of Safety; and possibly a good explanation of Buffett's own interpretation of the principle.

Buffett's and Thiel's statements are very similar in structure.

Definitions

When we study the methods of most successful investors, we see similar principles expressed and applied in different ways. But while almost everyone has heard of the Margin of Safety, in one form or another, only a select few such as those above understand it and apply it successfully.

Investment

a. The Intelligent Investor

Graham gave the following definition for an Investment in The Intelligent Investor:

"An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative."

Benjamin Graham, Chapter 1: Investment versus Speculation, The Intelligent Investor.

The application of the Margin of Safety is actually best explained in Graham's definition of investment above, i.e., never risk the principal amount; and is a function of the price paid.

b. Security Analysis

"An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative."

Benjamin Graham, Chapter 4: Distinctions Between Investment And Speculation, Security Analysis.

Graham explains in detail even in the second edition of Security Analysis why the fundamental differentiating factor between an investment and a speculation is the risk involved, which is directly a factor of the price of the investment.

The Margin of Safety is referenced several times in these earlier editions, but not introduced as a fundamental concept till the third edition in 1951 — presumably after the first edition of The Intelligent Investor in 1949 — where it is included as part of the name of the chapter.

Upside

The Margin of Safety is somewhat similar to what is often referred to in common financial parlance, especially in the context of Fundamental Analysis, as Upside.

But do note that the actual Upside value for an investment would normally be higher than its Margin of Safety; since Upside also has to consider any potential future increase in Intrinsic Value of the investment, resulting from retained Earnings and the ensuing growth in Per Share Earnings and Asset Values.

Margin

The Margin of Safety only considers current stock prices and Intrinsic Values, and is defined as:

"A favorable difference between price on the one hand and indicated or appraised value on the other. That difference is the safety margin."

Benjamin Graham, Chapter 20: “Margin of Safety” as the Central Concept of Investment, The Intelligent Investor.

The Margin of Safety is measured on GrahamValue using Intrinsic Value(%).

Risk

Graham repeatedly emphasized this counterproductive nature of risk in investment. Again, from The Intelligent Investor:

"There has developed the general notion that the rate of return which the investor should aim for is more or less proportionate to the degree of risk he is ready to run. Our view is different. The rate of return sought should be dependent, rather, on the amount of intelligent effort the investor is willing and able to bring to bear on his task."

Benjamin Graham, Chapter 4: General Portfolio Policy, The Intelligent Investor.

So Buffett was being quite literal when he said "Rule #1: Never lose money. Rule #2: Never forget rule #1.".

Videos

Buffett In 1985

The following clip of the Buffett Rules is from Adam Smith’s Money World: How to Pick Stocks & Get Rich that aired in 1985 on PBS. Buffett explains both the concept of the Margin of Safety, as well as the importance of thinking independently.

Buffett In 1962

While the above is possibly Buffett's first major television appearance, given below is a rare clip of him filmed for broadcast news in 1962. Buffett is 32 here, 23 years younger than in the clip above, and this is the first known visual recording of him. The video description on YouTube has more details.

Klarman In 2011

In the following video, Seth Klarman explains how he borrowed the title for his own book Margin of Safety from Graham's book Security Analysis — the latest of edition of which he wrote the Preface for — and how Value Investing characteristics may be genetic.

"While it might seem that anyone can be a value investor, the essential characteristics of this type of investor-patience, discipline, and risk aversion-may well be genetically determined. When you first learn of the value approach, it either resonates with you or it doesn't."

Seth Klarman, Preface (2008): Security Analysis (by Benjamin Graham).

"It is extraordinary to me that the idea of buying dollar bills for 40 cents takes immediately to people or it doesn’t take at all. It’s like an inoculation. If it doesn’t grab a person right away, I find that you can talk to him for years and show him records, and it doesn’t make any difference. They just don’t seem able to grasp the concept, simple as it is."