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The Quality of Margin of Safety

December 3, 2012

Value Investors in the traditional mold of Graham and Dodd swear by margin of safety. When you buy a rupee note for 60 paise, the forty paise is your margin of safety. The difference between the truth and the reality, the estimate and the known.

The closer the estimate is to the inherent truth, one has the luxury of making an investment with as low margin of safety as he warrants. So if one intends to sell another person a rupee for 90 paise, that 10 paise is his margin of safety and irrespective of a lower margin a rational investor will buy it. He will buy it, till its 99paise for an immediate gain of 1 paise.

However, when the estimate is just that-an estimate and the “truth”, the real intrinsic value lies in a hazy range the need for margin of safety becomes apparent. For a company whose estimated value lies between 300-650 range, and if the price of the security is 280,500 or even 700- the opportunity for profit in such a scenario become a matter of speculation and not that of certainty. However if the price of the same security quotes for a modest sum of 100, the margin of safety will take care of any possible error in the estimate and yet allow the investor to gain. This is the supreme logic in value investing and if one remembers this everything else is mere detail.

But the quantity of margin of safety is not the only markerĀ  in real life operations. In real life time is a variable which changes many things. When one offers a rupee for 60 paise, there is no way of the investment becoming more risky (i.e less margin of safety) without an increase in the quoted price of that rupee. I.e when the same rupee is quoted for 80 paise, there is a loss of 20 paise in margin of safety but there is also a 20 paise gain in the value of the investment. However in cases of business, time is a variable which can change things.Even if one doesnt make a single penny, he/she might stand to lose his margin of safety.
And here in comes the need for not only quantity but also quality of margin of safety.

Consider,

Problem 1: A business whose market value(the money you have to put on table to buy the entire business off) is 500crores. It has cash in its books worth 800 crores; net fixed assets worth 300 crores.

Expected Action of an intelligent investor: He will buy the business, liquidate the company, sell assets, pocket the cash.

Problem 2: A business whose market value is 500crores. It has cash in its books worth 800crores, net fixed assets worth 300crores and government regulation prevents one from liquidating a business.

Expected Action of an intelligent investor: He will buy the company and try to sell it off to a sophisticated investor who knows how to value to business better than Mr. Market.

Or buy a stake in the company and wait for Mr. Market to correct its mistake.

Sidenote: For those who believe that government preventing the liquidation of a business is improbable, it is indeed true for India where the byzantine corporate laws and labour laws make exiting a business prohibitively costly. One might sell the assets but can’t fire his employees.

Problem 3: A business whose market value is 500crores. It has cash in its books worth 800crores, net fixed assets worth 300crores; government prevents exiting a business and the company is losing 100crores per year.

Expected Action of an intelligent investor: None. He/She needs to wait to make Mr. Market correct its folly but waiting will lower his margin of safety and thus lower his prospective returns.

This points to one thing- not only the margin of safety but the quality of it is extremely important. Each investor should ask oneself -for 50 paise am I being offerred a rupee note, or a rupee worth of bond, or a rupee worth of a matured business, or a rupee worth of a sustainable growth business, so on and so forth.

Each successive option better than the previous one. But this is not the only metric. A rupee worth of business quoting at 80 cents with good management is far better than a rupee worth of business quoting at 30cents,saddled with bad management.

So its more important to ask , what do I get for free than merely asking- is there anything for free?

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