Imagine you’re driving a truck. Suddenly you approach a bridge with a big warning sign: MAX WEIGHT 2 TONS. You know the weight of your cargo is definitely one ton. You, then must estimate the weight of your truck. It’s a fairly large truck, so you guess it’s at least one half ton. Then there’s your weight and anything else you might have with you on the truck. That leaves only a few hundred pounds between crossing the bridge safely, or potentially crashing to your doom. Do you cross?
Most rational drivers would say no. Even though the combined weight of the cargo and truck might still be under the estimated two-ton limit, leaving such an important decision to such a relatively small margin of error is a reckless choice. Especially, if there’s another bridge up ahead with a ten-ton limit. The rational driver doesn’t leave a life-threatening choice to chance, and decides to take the bridge with the higher weight capacity.
Why write about trucks, tons, and bridges on an investment blog? Because this is the exact decision-making exercise that the Godfather of Value Investing, Benjamin Graham, describes in chapter 20 of his book, The Intelligent Investor. That is, the concept of buying a security with a margin of safety. In other words, it’s not enough for a security to be trading below value. There has to be a significant difference in the value of the stock and the price for it to qualify as safe.
To explore this idea further, let’s dive into one of our interviews with Paul Lountzis of Lountzis Captial Management.
In the video, Paul remarks on Warren Buffett and the margin of safety:
I think the margin of safety concept is one of the greatest if not the greatest concept ever created in investing. It’s Chapter 20 in The Intelligent Investor, the book that really impacted Warren Buffett written by Ben Graham. When I think of Mr. Buffett, even though many people think of the enormous wealth that’s been created and what a great investor he is, part of why he’s such a great investor is he almost never suffers permanent capital loss. What’s astounding is when you look at the investments he’s made over his lifetime both public and private, there are so few mistakes that it’s unbelievable. When I think of him, that’s what I think about. I think about always buying with a margin of safety, his ability to assess and manage and quantify risk from his reinsurance background and his extraordinary mathematical mind.
Supplement this video with a reading of Buffett’s classic article, The Superinvestors of Graham-and-Doddsville. Essentially, you have two things to consider when buying, price and value. Similarly when you’re driving the truck, you think about your weight and the capacity of the bridge. Just as it’s best to cross the bridge well under the weight capacity, it’s best to purchase far below the intrinsic value.
An extreme example of this occurs when companies trade below book value. In other words, if the company were to completely liquidate all assets, the net sales of assets would be greater than the company’s present market capitalization! While rare, this occasionally happens and activist investors attempt to do exactly this, what some would call buying dollars for fifty cents. Graham likes to use the metaphor of finding a discarded cigar butt on the ground and picking it up for one last triumphant puff. However you like to think about it, buying with a margin of safety significantly hedges potential purchasing mistakes.
Let’s Talk Moats
By now, we’ve discussed one of Warren Buffett’s favorite tools, the margin of safety, and the decision-making process behind what it actually means to proceed to purchase a security with a safe margin. But there’s another weapon in Buffett’s arsenal that requires its own imaginative thinking. That is, the moat.
Moats were used in the Middle Ages to slow down invading armies as they stormed castles. Once the soldiers (competitors) breached the castle walls, there was little hope for the defenders. If however, you could keep invaders away, long enough to react, you might stand a fighting chance. This millennium-old technique has been a fundamental component to defending the value of a company. Only, instead of water and crocodiles, companies use competitive advantages, product loyalty, and monopoly to defend their market share.
A moat is a defensive play. As Massimo Fuggetta, Manager of Bayes Fund, describes in the following interview, a moat is a sure way to defend against the company going bust.
That said, Massimo also brings up the point that companies with a moat, are typically valued at prices which include the moat, and the very same slow-moving factors that make the investment highly defensible, also prevent rapid growth. If you’re looking for companies that will not just match the market, but outpace the market, Massimo says that he looks elsewhere.
While companies with rapid growth might contribute better returns to the portfolio, it’s important to remember, that growth is not necessarily an indicator of a moat. To touch on this final point, let’s look at this short clip of Pat Dorsey, Investment Manager of Dorsey Asset Management.
“Anyone can grow, that doesn’t mean it’s sustainable,” says Dorsey. While some companies ride terrific ups, they can just as easily suffer spectacular downs. While investors like Massimo seek returns in a company’s growth potential, the moat provides a beacon of stability.
The margin of safety and the moat are two of the biggest concepts for value-seeking investors. When determining value, defensibility in the form of a formidable market-share moat is a highly sought after characteristic. As Paul Lountzis says in the earlier interview, over the course of Buffett’s career, he’s made “unbelievably few” mistakes. In fact, when asked about his greatest mistakes, Buffett usually says they’re almost always mistakes of omission rather than commission. In other words, it’s not his actions that get him in trouble (unless they’re airline related, but that’s another blog), but his caution that prevents potential returns.
Yet, in the industry of capital allocation, which values track-record above all else, Benjamin Graham’s margin of safety has proven itself to be a most useful guide. Happy bridge crossings.