The formal definition of margin of safety is buying the stock below the intrinsic value. This official definition doesn’t help in practice. Here we offer some thought to help investors grasp this iconic idea.
In This Issue
From One Misconception to Another Misconception
The Margin of Safety and Intrinsic Value Should be Intuitive, Not Precise.
Too many questions arise when critical investors read the concept of margin of safety. First, what is intrinsic value? Answering this question alone will bring headaches and endless debate. Then, how wide is that margin needed? The answer from investors will vary and instead of getting a better understanding, new investors become more confused.
What we like about Warren Buffett (Though he is not the one that invents that terminology) is his simplicity and logical reasoning without too much complex financial and accounting vocabulary. Thus, the idea of margin of safety – if he talks repeatedly – should be simple too.
And if setting the intrinsic value is impossibly difficult, why bother?
Do you feel it is still abstract? Good, follow us in the next section.
Why Value Investor Miss Tesla
The Margin of Safety is The Reason for That Decision
Aswath Damodaran, one of the value investor gurus1 has said that Tesla is overvalued since 2013. At the end of 2020 – 7 years from his statement, Tesla’s stock price sped up more than 100 times of its 2013 level. So, can we say that value investing miss one of the greatest investment opportunities in the United States?
The list could go on and on, like Titanic OST…we could add Bitcoin, maybe even metaverse world.
The reason is the margin of safety.
We continue with Warren Buffett parable: Well, if you’re driving a cybertruck across a bridge that holds — it says it holds 10,000 pounds — and you’ve got a 9,800-pound vehicle, you know if the bridge is about few inches above the fissure that it covers, you may feel all right. But if it’s, you know, over the mighty Grand Canyon, you may feel you want a little larger margin of safety, by only driving a 4,000-pound truck or something.
Value investing is driving a 4,000-pound truck instead of becoming the acrobatic driver that can pass through the dangerous road with a full load. As consequence, value investing is never be cool – that’s not its purpose. Buying Tesla in this valuation – 1,000 earning multiple – is like walking on the rope over Grand Canyon. It is maybe cool. But No, Thanks. And even though it is way overvalued, we are sure that Tesla’s stock price will perform at full gear again in 2022.
So Back to the main topic. What is the margin of safety? Simply not taking excessive risk.
Circle of Competence
The Margin of Safety Means Protecting Against What You Don’t Know
You know nothing, Jon Snow. What Ygritte said to Jon Snow is sometimes also true for us.
Risk comes from what we don’t know.
If Margin of safety means eliminating or at least minimizing the risk, so, we need to get more information and knowledge to fill that risk gap. We need to expand our circle of competence.
Well, it needs to be responded to by two different sides. First, we always have a mandatory task to improve and upgrade ourselves. To get more information, get a better understanding, get to know more about accounting stuff and business in detail. But, still, there is a limit to this boundary. So, yes, we need to expand our circle of knowledge. But, there are things you can control. There are still things beyond your knowledge.
That is when the risk comes.
For example, we know that EV someday becomes mass production. Battery energy density will improve, the electric grid and charging facility will come at scale. That is what we know. But we also know, competition will heat up. Jinping – as the second-largest economy – will not go easy on Tesla. His in-house EV will get full government support. And, what about other automakers like Toyota, Ford? They will not sit quietly. With galactic valuation – 1,000 earnings multiple – upcoming competition, the risk simply exceeds the potential.
Why Did Buffett Said That?
The margin of safety, as we have said earlier, is one of the most misunderstood terms. So, without getting more speculation, lets us back to when Buffett said it. Maybe by knowing the circumstances of that time, we could understand this concept better.
As far as we remember, Buffett ever said about the margin of safety in his annual letter to shareholders (partner, Buffett call it.) 3 years before this letter, that is, 1959, in his foreword, Buffett said that the stock market is higher than its prices. In 1962, the US face another market turmoil that was well known as the Kennedy slide.
Here is the full quote:
So actually Buffett talked bout not going to take an excessive risk or not paying too much for the stock market.
The Beginning: Problem With Benjamin Graham
In the Market that is dictated by Intangible Wars, It is More Complicated to Guessing Margin of Safety.
With its famous cigar butt approach, Benjamin Graham is the first that introduced the margin of safety. This sentence seems simple, but for us, it has meaningful consequences. Graham lived in a world when tangible assets are heavy, his predecessor, Warren Buffett, also spans his life in almost the same characteristic.
Without undermining Graham’s genius work, we see that the tangible asset or book value gives a simpler calculation for the margin of safety since it is calculable. The real asset – for instance, Marriott with its hotel, Exxon with its proven reserve – provide enough cushion for the company when its price plummeted.
You can’t do a book value approach like Graham for modern-day where intangible rule the world. We need something else -and we will cover it in the next article. See ya.
- according to people and his essays