Margin of Safety

Wikipedia defines ‘Margin of Safety’ as the difference between intrinsic value of a stock and its market price. Benjamin Graham and David Dood, founders of value investing, coined this term.

In the speech Super investors of Graham-and-Doddsvile given by Warren Buffett in 1984, commemorating the 50th anniversary of Security Analysis, he defines Margin of Safety as ‘Buying 1 dollar for 50 cents.

Excerpt from the speech.

You also have to have the knowledge to enable you to make a very general estimate about the value of the underlying businesses. But you do not cut it close. That is what Ben Graham meant by having a margin of safety. You don’t try and buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And that same principle works in investing.

Why do we need Margin of Safety?

We need Margin of Safety to protect us

1. From our mistakes and biases.
2. From unexpected market downturns like what happened in 2000 and 2008.
3. To have a peaceful sleep.

This principle is practiced by many businesses to protect themselves from going bankrupt. Let us look at some of the examples

1. Casinos

Have you ever wondered why casinos are profitable? I found the answer in this extraordinary interview given by Sanjay Bakshi.

1. Every bet made by every gambler has odds tilted in casino’s favor.
2. You have lots of customers i.e. you practice diversification.
3. You put a cap on the maximum bet that can be made by any customer on a single gamble.

2. Insurance

Warren Buffett tells that a sound insurance operation requires 4 disciplines.

1. An understanding of all exposures that might cause a policy to incur losses;
2. A conservative evaluation of the likelihood of any exposure actually causing a loss and the probable cost if it does
3. The setting of a premium that will deliver a profit, on average, after both prospective loss costs and operating expenses are covered;
4. The willingness to walk away if the appropriate premium can’t be obtained.

3. Non-Banking Financial Companies

In India Non-Banking Financial Companies(NBFC) are businesses engaged in the activities of loans and advances. They use Gold as collateral for lending money to their customers. How do they protect themselves?

1. Impose a cap on the loan to value(LTV) ratio to 60% of the value of the collateral(Gold). For giving out a loan of Rs 60/- the company will retain gold worth of Rs 100/-
2. Lends to a large customer base of 1.6 million.
3. Limit the maximum loan amount to Rs 10 million.

In all of the above examples, you can clearly see Margin of Safety in action. Without it none of these businesses can survive. If the businesses use this principle as the foundation should we individuals not embrace this? I believe we all should.

4. Savings

Most of us need income from our pay check every month. What happens if it stopped? In order to handle this situation it is better to keep 6 months of expenses in a safe place. Do not worry about the interest. The mental satisfaction this provides is much greater than the interest income. Given below is the letter which Warren Buffett shared in his 2010 letter to the share holders.The letter is written by his grandfather Ernest’ to his youngest son Fred.

5. Real Estate

When buying real estate for investments, it is better to apply Margin of Safety. We can think about it in two ways

1. Replacement Cost
   
2. Capitalization Rate

If it takes $100,000 to construct a new house and you a buy an existing house for  $60,000, you have an excellent downside protection. Why? Builders will lose money if they sell new homes for $60,000 as the construction cost itself is $100,000. The loss will be $40,000($60,000 – $100,000). This gives a reasonable downside protection as there is Margin of Safety.  Excerpt from the book Investing in Real Estate – Gary W. Eldred

Replacement cost typically sets the upper limit to the price you would pay for an existing property. If you can build a new property for $380,000(including the cost of a lot), then why pay $380,000 for a like-kind existing property located just down the street?

Capitalization Rate is defined as given below

Capitalization Rate = (Net Operating Income/Purchase Price) * 100

Let us imagine you purchased an investment property for $110,000 by paying 25% down $27,500 and taken a 75% mortgage $82,500

 Operating Profit(Pre Tax)           = $7,211.00
 Mortgage(Principal + Interest)      = $4,726.44(4%/30 year fixed)
 Net Profit After Financing Expenses = $2,484.56

The capitalization rate comes to 6.56%($7,211/$110,000). The mortgage payment comes to 4.29%($4,726.44/$110,000). There is a margin of safety of 2.25%($2,484.56/$110,000) to protect us from adverse situations. The Debt Coverage Ratio is 1.53($7,211/$4,726.44). Excerpt from the book Investing in Real Estate – Gary W. Eldred

One such investor bought a $300,000 fourplex with a down payment of $30,000. After paying property operating expenses and mortgage payments, the investor faced an alligator (negative cash flow) that chewed up $1,000 a month.

If we had thought about real estate in this way, the crash of 2008 might have been avoided.

6. Databases

Sometime back, I was monitoring the Oracle database CPU usage. It was around 18%. The DBA(Database Administrator) who was sitting next to me, commented, once the CPU usage goes above 20% the database should be moved to a bigger box. I was surprised and asked him why? The answer he gave was

If the CPU usage is below 20%, we are giving sufficient room for handling any unexpected spike in traffic.

He was following Margin of Safety.