Warren Buffett’s 3 Cornerstones of Sound Investing

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Margin of Safety

Warren Buffett’s third cornerstone of sound investing is to invest with a margin of safety.

The margin of safety is the discount between your calculated intrinsic value of a stock and the current market price of a stock.

If you believe shares of a company are worth $100, but they are only trading for $70, then you have a 30% margin of safety. You could be wrong on your intrinsic value calculation by up to 30% and still break even.

The margin of safety concept is extremely important in an uncertain world. Valuing a business is very difficult – there are many variables and moving parts to even simple businesses that make knowing the true exact intrinsic value impossible.

That’s why the margin of safety is so important – because intrinsic value calculations are not precise.

Before going any further, the intrinsic value of any asset is the sum of its future cash flows discounted back to present value with an appropriate discount rate.

Unless you can see the future with crystal clarity, you can’t come up with an exact intrinsic value.

This only necessitates having a margin of safety. In an imprecise world, a buffer against errors is needed.

The larger your margin of safety, the better. It would be foolish to buy a business you think is worth $100 for $98. There’s no room for error. If you are off in your calculations by just a few dollars in the wrong direction then you’ve overpaid.

The deeper the discount to intrinsic value a stock is trading, the more likely it is to be a profitable investment. Said another way, the deeper the discount to intrinsic value, the more things that can go wrong in an investment for it to still be profitable.

Interestingly, stocks tend to trade for their highest margin of safety (deepest discount to intrinsic value) after negative events have already occurred.

This is beneficial for investors because it brings to light problems that may have been difficult to recognize beforehand, and gives you a bigger room-for-error if future problems hamper a business.

Not every investment requires the same margin of safety. You would need a tremendous margin of safety to invest in a high-risk biopharma startup. On the other hand, investing in a business that has proven itself by paying rising dividends over decades – perhaps one of the 50 Dividend Aristocrats – you need less of a margin of safety because future cash flows are more secure.

The more secure future cash flows are, the lower a margin of safety is needed.

The market partially prices this in already. High quality businesses tend to have lower stock price standard deviations; they (on average, historically) fall less during recessions – meaning you get a smaller margin of safety versus riskier stocks.

Adding a margin of safety to your investing arsenal will help to avoid mediocre investments. It will also help to reduce your risk of buying overpriced securities.

Finding an appropriate margin of safety for an individual business is an art, not science. I know that The Coca-Cola Co (NYSE:KO) needs a smaller margin of safety than Twitter Inc (NYSE:TWTR), but exactly how much is hard to say. With Twitter’s precarious business position and presence in a rapidly changing industry, I would need a very large margin of safety before considering an investment in the company.

On the other hand, an investment in Coca-Cola requires a much smaller margin of safety because the company operates in the slow-changing low-tech beverage industry and has proven for over a century that it can reliably grow its business through developing new beverage brands and through continuous international expansion.

Many successful investors use the margin of safety concept.

Seth Klarman – the billionaire value hedge fund manager of Baupost Grouptitled his bookMargin of Safety. That shows how critical the concept is to him.

“A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world.”
– Seth Klarman

Warren Buffett describes the concept of Margin of Safety as follows:

“Leave yourself an enormous margin of safety. You build a bridge that a 30,000 pound truck can go across and then you drive a 10,000 pound truck across it. That is the way I like to go across bridges.”

Buffett, Klarman, and Benjamin Graham have all employed the margin of safety concept effectively – and build fortunes, which shows how important the concept is to successful investing.

Final Thoughts

Two out of three of Warren Buffett’s sound investing cornerstones are psychological. Thinking of stocks as small pieces of businesses and viewing market fluctuations as your friend are not hard-and-fast investing rules. They focus on the mindset of the investor.

Investor mindset is the most critical aspect of investing. Without sound investing principles, your investment performance will suffer as you switch from this investing fad to that investing fad.

With sound principles, you can invest in great businesses for the long-run.

Warren Buffett is arguably the greatest investor of all time. He has simplified and distilled Benjamin Graham’s message – and added to it. You can see Warren Buffett’s 20 highest yielding stocks here.

Together, Warren Buffett’s 3 cornerstones of sound investing urge investors to think about stocks as businesses, not get fooled by market prices, and to invest in undervalued securities. There is little doubt these rules will stand the test of time – just as they have sense Benjamin Graham first discussed them.

Disclosure: None

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