Like many of you, I was indoctrinated into investing by reading about Warren Buffett. The first serious investing book I read was called “The Warren Buffett Way” by Robert Hagstrom. My girlfriend at the time (now my wife – having that book really clinched the deal) had it on her bookshelf. She never read it, but I devoured it in one sitting. I was a value investor! I’d found the light! I’m not, and I probably never really was, but that’s a story for another time. The book was pivotal for me because it was the first book I read that provided a framework for investing that I truly understood. It also introduced me to the applying a Margin of Safety (MOS) to investing.
I have an engineering background. Anyone with a technical background is familiar with the concept of margin of safety. In fact, it’s so ubiquitous, that we don’t even capitalize it when we write it. For some investors, it is more like a commandment (imagine “Margin of Safety!” boomed out in a Wizard of Oz type voice any time you read it in an investing context). The concept is simple, if you design something, you don’t design it to handle the forecast load, you design it to handle much more than the forecast load. If you expect to design a bridge for 10,000 lb. trucks, you make sure it can handle 20,000 lb. trucks or 50,000 lb. trucks. This provides protection in the event your design is flawed or degrades over time.
Applied to investing, the concept is similar. If you think a company is worth $50 per share. You don’t buy it for $50 per share, you buy it for $40, or $30. This provides a “buffer” if you are wrong in your analysis. It’s an elegantly simple concept. And that concept, along with fundamental business analysis, almost immediately improved my investing. Not to crazy stratospheric hedge fund like returns, but once I adopted this mindset, I started to have consistent positive returns. Now, I didn’t run out and beat the market, but at least I stopped losing all my money.
Over time, I started to realize that this is a heavily flawed concept. Because, well, it never worked the way I thought it was supposed to work. For one thing, I thought utilizing a margin of safety would prevent me from losing money (it didn’t). I thought it was some sort of guarantee that the stock price wouldn’t go down, or if it did, it wouldn’t go down much (it isn’t). I think it’s a valuable framework to think about things. But I no longer really consider it to be a defining characteristic of my investment style.
“… you can buy this at a fraction of tangible book value! It trades at 0.5X tangible book value and half of the market cap is in cash! You literally can’t lose money in this stock!” - Unknown investor
This quote, or something very similar, is something that I read on a message board after I had been investing for a while. It illustrates the illusion that margin of safety creates. At half TBV (tangible book value) you should theoretically be able to break up the company and sell it off and double your money. What a great margin of safety! Unfortunately, there is no “rule” that says a company that is trading at 0.5X TBV can’t trade at .4X or .1X or zero for that matter. And if the company is destroying value, then it can certainly continue to decrease in price, all the way to zero.
I have this lesson etched in my brain. I invested in a company (that shall remain nameless) based on a significant discount to TBV. The company was in a bit of distress, but cheap – very cheap. It was trading at a significant discount to TBV. It was so cheap, I figure that even if it went through bankruptcy, I would still make money. I was wrong. It did indeed go bankrupt. The first thing that happened, they awarded bonuses to retain key management. This was to incentivize them to remain in place and run the company through bankruptcy. Then they had to hire bankruptcy advisors and lawyers. I have no doubts that somebody made good money off this transaction. The company owned many industrial assets worth real money. But the stockholders made nothing. The stock went straight to zero.
I’ve forgotten how many Margin of Safety (see that capitalization!) investments I have made over the years that continued to drop in price after I bought them. This is my own personal experience, and not an indictment of the concept. Other people much smarter or with better insight might use the MOS with incredible investing success. But while the concept helped improve my investing, it was not the silver bullet I thought it was. It sometimes gave me a false sense of confidence and led me into many investing mistakes.
Next time, I will share one of the common MOS value frameworks and mistakes I’ve made using it.
A good read, Brian. Thanks. And have one of those cold ones for me! /Rick Regan