The margin of safety is inherent to value investing. It was first coined by Benjamin Graham in 1949, Warren Buffet’s teacher, and has since spawned many value investors that have achieved great returns.
A margin of safety in value investing is buying a business for less than it’s worth, or intrinsic value. It is essentially bargain hunting; buying a dollar for fifty cents. A margin of safety provides some insurance against investor mistakes and future unknowns.
What is a margin of safety in value investing?
A value investor’s primary goal is not to lose money. A margin of safety provides some insurance against analytical error or bad luck when investing. This margin is vital as humans make errors, the future is unpredictable, and valuating businesses is imprecise. The margin of safety is inherent to value investing; to pay less than the underlying value of an asset. It is essentially bargain hunting; buying a dollar for fifty cents. It may take looking at hundreds of companies before finding one that is sufficiently discounted. Alternatively, an investor can have a wish list of great companies they would like to own and wait for them to go on sale.
Waiting for the right time to invest
Value investing is a waiting game. It requires extreme patience for an investment’s value to be realized by the market and to wait for the right investment to come along. The great thing about value investing is that you do not have to reach a quota of capital allocation; you can wait a year or pass by hundreds of opportunities before buying. Understanding the business is crucial to value investing, not only understanding the business itself but also where it will likely be in 10, 20, or 30 years. Some investors may not understand technology, whereas others may find valuing a bank too difficult. It is also essential to remember opportunity cost; if a better opportunity comes along than the one you have, it makes sense to sell the lesser investment for the better one. The aim is to hold a position for long periods but do not forget that weighing your current positions against everything else is the best measuring stick investors have for valuing a business.
The impreciseness of business valuation
When valuing a business, knowing everything that would affect its future performance is impossible. Even if everything could be known about a company today, we still cannot know what its future growth will be; we do not know if the management will change, whether consumer preferences will change, if the company will continue its pace of innovation, or what direction interest rates will go. Buying a company with a margin of safety gives some level of protection from this unpredictability. It is essential to understand the business, both how it operates and makes money and where it will be in the future. Staying within your circle of competence, what you know and understand, gives you a better chance of being able to accurately predict the potential of an investment.
Investing with your circle of competence
Every person on this planet has experiences and knowledge unique to them. Each piece of expertise gained from studying at school, work experience, or life wisdom creates a tool kit for navigating life. This combination of the tools may best serve certain areas while inadequate in others. In investing, it is essential to understand a business before investing in it. Knowing what businesses you understand and do not understand is critical to successful investments. Stepping outside of your area of expertise significantly increases the chances of failure.
The circle can be thought of as having an inner, middle, and outer circle. The inner circle is your true circle of competence, which includes business that you can thoroughly understand. It is not the size of the circle is not important; knowing where the boundary is. The more experience you gain, the larger this circle expands.
The middle circle is the most dangerous area. It involves companies you know something about but not enough to understand deeply. This is where many investors get into trouble because they can become complacent about the amount of expertise they have about a company. For example, an investor may have read a company’s financials, but they may not know how good the management is at decision-making. And it is the company’s management that can make or break a business.
The outer circle includes the companies you know nothing about. These companies are the easiest to discard as they are often the most complicated. For example, how many investors have a deep understanding of pharmaceuticals? And even if they are knowledgeable in pharmaceuticals, they will need extensive knowledge of the particular class of drugs.
Finding your circle of competence
Your circle of competence is the area of interest you have a deep understanding of. You can look at your work experience, the products and services you use regularly, or even your hobbies to find it. For example, if you have been working in the semiconductor manufacturing business for decades, you know what the best company is and how likely it will stay the best company. A good indication of your level of knowledge is if you would be able to talk at length about the industry if asked. To determine how much you know about a company, you will need to understand its competitive advantage, the strength of its competitors, the competency of its management, its rate of innovation, cost drivers, growth drivers, and risks associated with investing in the company.
What you think is in your circle is most likely less than what is inside. Multiple human psychological biases can mislead investors into thinking they know more than they do. Even if investors are highly knowledgeable about an industry, they may still have negative behavioral tendencies, miscalculations, and blind spots. For example, they may be subject to confirmation bias, which is the tendency to search for information that supports their opinion and reject any contrary information. Investors must look at all info objectively if they are to be successful. There may also be a miscalculation in probabilistic thinking, which helps investors calculate the chance of investment losses. This is particularly important as the number 1 rule of investing is not to lose money, and investment risk is defined as the chance of permanent capital loss. It is one of the best tools for estimating our chance of success.
