The Margin of Safety Application: Misconception

We believe our article that explains the Margin of Safety brings you here. This post is the sequel of that series. Differ from the prequel, this time we will elaborate further on the Margin of Safety application.

In This Issue

Sherlock Finds The Cigarettes
The margin of Safety Application Using an Asset-Based Approach.

Before we take the modern world example, let us set back to the early days when the concept was introduced. We believe Margin of Safety by Graham has a strong correlation with his cigar butt approach. The idea behind is simple. Just finding the hated stock and the most discarded one, but with value left. It is analog with cigars that had been thrown. It looks ugly, disgusting. But there is a last puff, and it is free.

How apply it in the financial world?

Suppose we are in the commodity crash where the oil price goes to almost $4 per barrel due to EV massive adoption. In these circumstances, the price of an energy company like Exxon follows the commodity. Let’s say its market cap crashed to just shyly $1 Billion. And because Exxon oil production costs $8 per barrel, it records negative earnings during low oil prices situation. In this case, Exxon looks hopeless.

Let’s imagine that Exxon has a massive amount of oil reserves in Guyana. That is around a billion metric tons. Converting these resources into Barrel oil gives us 7 Billion, multiplying it with $4 per barrel of oil, $28 B. we have which exceeds the market cap.

The cigar butt investor sees it as a potential. The $7 billion serves as a comfortable cushion that can be counted on when something bad happens. The difference between the reserve (7 B) and the market cap (4 B) is the margin of safety.

This calculation does not show up in the financial or annual reports. This is ours.

More About Cigar Butt

Before going to the next section, we would like to remind investors of an important point. To get works, the selection of the asset that serves as a cushion needs to be of high quality. For instance, land and property assets of Hotel companies like Hyatt or Marriott. Since the value of land and properties will grow as time goes, not the opposite. As a consequence, companies like Maersk, Caterpillar, or Airlines can’t be approached by this method since their asset is depreciated or declined as time flies. At the end of their lifetime, ships, submarines, excavator or aircraft are just old metal.

Doing Too Much
The Margin of Safety Application in Value Investing

The most misunderstanding in the margin of safety application is to seek the cheapest company, to get the thickest margin. Motivated by the cigar butt method we discussed in the previous chapter, investors tend to find out the company with low valuation matrices in order to apply a margin of safety.

Let us ask you a question.

Do you think you can get wealth by finding a free cigar that is thrown in the street? Really? No. You have the same answer as us. To get wealth, you can’t depend on cheap things. So, what do we need to seek? If not the cheap and battered one, so which one? Let’s back to Warren Buffett once again.

Benjamin, Charlie, and Warren.

In case you don’t know, Warren Buffett’s investment approach has changed over time. Before meeting Charlie, Buffett was overwhelmed by the idea of a cigar butt. No surprise since he is the heir of Benjamin Graham’s wisdom. But, as Berkshire’s size becomes bigger and more complex, Charlie wakes him.

As Warren Buffett himself testifies:

Charlie emphasizes that even cigar butt work so well, it lacks the capability to scale Berkshire up. Besides, it has a lot of risks and limitations. Charlie’s method is finding a good company, best in class. It doesn’t matter if he pays more premium as long as he gets the best.

This is the beginning of the investing wisdom you read everywhere.

“Buy wonderful company instead of wonderful price”

“Time with the market instead of timing the market”

“First-class businesses accompanied by first-class managements.”

Economic Moat is Your Margin of Safety
The Margin of Safety Application is Assessing Barrier to Entry

So what is the margin of safety? How apply or estimate the margin of safety? From the previous section, the clue is clear and loud. The better its business, the thinner margin you need. And vice versa, the worse the business, the riskier it is to invest.

So, the question of how much margin of safety is needed becomes the question of how good is the business?

Putting All Ideas Together
All the Iconic Words in Value Investing World.

So, let’s revisit the most iconic words in value investing. We have intrinsic value. We have a margin of safety. we have an economic moat. All of Warren Buffett’s words. How could it relate one each other?

Intrinsic value is dictated by the durability of competitive advantage. Earning, Revenue, Number of subscribers, Free cash Flow, Asset, all juts product. As you can read here.

Also, that durable competitive advantage serves as a boundary that helps us assess how risky certain company in the long run. So it also serves as a margin of safety. If you know that visa economic moat is unbreakable, you will think that it is less risky.

Revisit Idea of Value Investing
A Whole Idea of Margin of Safety Application

The idea of margin of safety should redefine your concept about value investing. No, It is not about timing. It is not about being at right time. We remember a misconception about fat loss. Most of us think that eating at night makes you fat. No, it is not about the timing of your eating. It is about what you eat. To have a body like Jeff Cavaliere from Athlean X or Chris Herria, you need dedication to what you eat, not the time.

Same with investing.

It is not at what price you buy stock.

It is which stock you buy.