Charlie Munger and Warren Buffett on Margin of Safety

 

All the passages below are taken from the book “Charlie Munger---The Complete Investor” by Tren Griffin. It was published in 2015.

 

Second Principle: Buy at a Significant Discount to Intrinsic Value to Create a Margin of Safety [31-36]

 

The idea of a margin of safety, a Graham precept, will never be obsolete.

-CHARLIE MUNGER, WESCO ANNUAL MEETING, 2003

 

No matter how wonderful [a business] is, it's not worth an infinite price. We have to have a price that makes sense and gives a margin of safety considering the normal vicissitudes of life.

-CHARLIE MUNGER, BBC INTERVIEW, 2009

 

Munger is making the point that if there is a single principle that should rise above all others in the mind of a Graham value investor, it is margin of safety. No one makes this point better than Ben Graham himself:

 

Confronted with a challenge to distill the secret of sound investment into three words, we venture the following motto, MARGIN OF SAFETY

-BEN GRAHAM, THE INTELLIGENT INVESTOR, 1949

 

What is a margin of safety? Ben Graham's definition of a margin o f safety is "a favorable difference between price on the one hand and indicated or appraised [intrinsic] value on the other."' Intrinsic value is the present value of future cash flows. Margin of safety reflects the difference between the intrinsic value and the current market price. The purpose of a margin of safety is quite simple according to Graham: "The function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future."9 Seth Klarman described the Graham value investing system simply: buy at a bargain defined by a margin of safety and wait. However, as the Tom Petty and the Heartbreakers lyric says, "The waiting is the hardest part."

A margin of safety for investors in public markets is analogous to a safe following distance when driving on the freeway. The intent of both approaches is to avoid having to make predictions. With sufficient distance between you and the car ahead, you must react to what you see in the present moment, but you do not need to predict the actions of the driver ahead of you. If you drive only a few feet behind the speeding car ahead, you need prediction instead of just reaction; otherwise, you are going to crash. Simply put, your objective as a Graham value investor is to buy a share of stock at a sufficiently large bargain that you do not need to predict short-term price movements in the stock market.

The margin of safety principle is natural for a person like Munger, who is trying to succeed by avoiding what is hard (e.g., predicting the future in the short term). He has learned to take the ordinary person's desire to solve hard problems and turn it on its head. Seth Klarman wrote:

 

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, MARGIN OF SAFETY, 1991

 

The last point made by Klarman is essential. Making successful predictions about complex systems is a process in which errors are inevitable. Having a margin of safety means that even if you make mistakes, you can still win. And if you do not make mistakes, your win will be even bigger. Munger has a clear view:

 

In engineering, people have a big margin of safety. But in the financial world, people don't give a damn about safety. They let it balloon and balloon and balloon.

-CHARLIE MUNGER, BERKSHIRE ANNUAL MEETING, 2003

 

If you could take the stock price and multiply it by the number of shares and get something that was one third or less of sellout value, [Ben Graham] would say that you've got a lot of edge going for you. Even with an elderly alcoholic running a stodgy business, this significant excess of real value per share working for you means that all kinds of good things can happen to you. You had a huge margin of safety---as he put it---by having this big excess value going for you.

-CHARLIE MUNGER, UNIVERSITY OF SOUTHERN CALIFORNIA (USC) BUSINESS SCHOOL, 1994

 

Munger believes that the margin of safety process in investing is similar to processes that exist in engineering. For example, if you are building a bridge, as the engineer you want to make sure that it is significantly stronger than necessary to deal with the very worst case. Buffett wrote once: "When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And the same idea works in investing."10 Munger believes investing should be similar. The first rule of investing is: do not make big financial mistakes. The second rule is the same as the first rule.

Behind the margin of safety principle is the simple idea that having a cushion in terms of excess value can protect you against making an error. If you buy at a discount, you have a margin of safety, which will help protect you from making mistakes. This will improve your odds of success. Everyone makes mistakes, so having insurance against those mistakes is wise. Finding an investment opportunity with the right margin of safety is uncommon, so you must be patient. The temptation to do something while you wait is too hard for most people to resist.

As Munger has found over the years, by making certain variables that do not change the four fundamental principles of the Graham value investing system and instead building on top of them, the system has been able to evolve as investing conditions have changed.

 

Ben Graham followers ... started defining a bargain in a different way. And they kept changing the definition so that they could keep doing what they'd always done. And it still worked pretty well.

-CHARLIE MUNGER, USC BUSINESS SCHOOL, 1994

 

Munger's use of the word bargain in the quote immediately above is important. It is not enough for a stock to be beaten down in price or off its highs. What is cheap to buy relative to the past may in fact not be a bargain in the present. To deliver a margin of safety to the Graham value investor, the stock must be worth significantly more than what he or she paid. How significant the bargain must be will be discussed later. The Graham value investor should always remember this admonition: price is what you pay, and value is what you get. It is common for Graham value investors to say things like, "My goal in buying a financial asset is to buy a dollar for 70 cents." When they say this, they do not mean "buy a dollar for seventy cents" precisely, but they do seek a significant discount from intrinsic value. Put simply: when a Graham value investor can buy a dollar for a few dimes less than actual value, he or she can make significant mistakes and still make a profit.

 

Ben Graham had a lot to learn as an investor. His ideas of how to value companies were all shaped by how the Great Crash and the Depression almost destroyed him, and he was always a little afraid of what the market can do. It left him with an aftermath of fear for the rest of his life, and all his methods were designed to keep that at bay. I think Ben Graham wasn't nearly as good an investor as Warren Buffett is or even as good as I am. Buying those cheap, cigar-butt stocks [companies with limited potential growth selling at a fraction of what they would be worth in a takeover or liquidation] was a snare and a delusion, and it would never work with the kinds of sums of money we have. You can't do it with billions of dollars or even many millions of dollars. But he was a very good writer and a very good teacher and a brilliant man, one of the only intellectuals---probably the only intellectual---in the investing business at the time.

-CHARLIE MUNGER, JASON ZWEIG INTERVIEW, 2014

 

What Munger is saying above is that what Ben Graham did in applying the concept of a margin of safety in his era was quite different from how investors (like Munger and Buffett) use it today. Look at history. In the aftermath of the Great Depression, Graham was spending most of his time searching for companies "worth more dead than alive."" The stock market crash and the Great Depression caused many people to simply give up on owning stocks. For a long time after the Great Depression, some companies could be purchased at less than liquidation value. While these so-called cigar-butt companies were common during this period of time, as years passed they became harder to find in major markets. Graham himself said this late in his life, which confuses many people to this day: the fact that public companies were no longer trading at less than liquidation value did not mean that it was no longer possible to use the Graham value investing system successfully.

As a result of the new post-Great Depression environment, Munger and many other Graham value investors began to apply the same Graham value investing principles to businesses that were of high quality instead of businesses trading below liquidation value---and the margin of safety process worked just as well. The variables that supplement the Graham value investing system began to evolve for some investors. Considering the quality of a business when valuing a business will be discussed later in the book.

Walter Schloss, Howard Marks, Seth Klarman, and a few other Graham value investors have stayed closer to Graham's cigar-butt style and instead focused on less-traded markets, given that there are only a small number of cigar-butt opportunities in major public markets. Howard Marks pointed out that "active management has to be seen as the search for mistakes."12 In his view, it is in less-traded markets and so-called distressed assets where mistakes are most likely to be found.

 

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Second Variable: Determining the Appropriate Margin of Safety [117-120]

 

Margin o f safety is a simple idea that is applied in different ways by different investors. Some investors like to have a margin of safety that is much larger than others. For example, one Graham value investor may require a 25 percent margin of safety, whereas another needs 40 percent. Of course, because the concept of intrinsic value itself is imprecise, the calculation of margin of safety is necessarily imprecise. Making things easier is the fact that Munger and Buffett like the amount of a margin of safety to be so big that they need not do any math other than in their heads. Of course, Buffett and Munger can do more mathematics in their heads than an average person can do on a calculator, but the point remains. Munger wants the math involved in evaluating an investment to be simple, overpoweringly clear, and positive. Bill Gates has commented on this point:

 

Being good with numbers doesn't necessarily correlate with being a good investor. Warren doesn't outperform other investors because he computes odds better. That's not it at all. Warren never makes an investment where the difference between doing it and not doing it relies on the second digit of computation. He doesn't invest---take a swing of the bat---unless the opportunity appears unbelievably good.

                  -BILL GATES, FORTUNE, I996

 

Many people make the mistake of assuming that buying a quality company ensures safety. A given company may be a quality company with an attractive business, but that alone is not enough because the price you pay for a share of stock matters. A company like Facebook, Nike, or even Berkshire may be an important company with lots of revenue and profit, but its business is not worth an infinite price. Howard Marks put it best:

 

Most investors think quality, as opposed to price, is the determinant of whether something's risky. But high quality assets can be risky, and low quality assets can be safe. It's just a matter of the price paid for them.... Elevated popular opinion, then, isn't just the source of low return potential, but also of high risk.

-HOWARD MARKS, THE MOST IMPORTANT THING, 2011

 

Similarly, just because the price of a share of stock in a company is beaten down from formerly high levels does not make it safe to buy. In other words, that a given company is way off its value of a few years ago does not necessarily make the purchase of the stock safe in terms of a margin of safety.

Munger talked once about the concept of margin of safety in describing Buffett's mentor Benjamin Graham in this way:

 

Graham had this concept of value to a private owner---what the whole enterprise would sell for if it were available. And that was calculable in many cases. Then, if you could take the stock price and multiply it by the number of shares and get something that was one third or less of sellout value, he would say that you've got a lot of edge going for you. Even with an elderly alcoholic running a stodgy business, this significant excess of real value per share working for you means that all kinds of good things can happen to you. You had a huge margin of safety---as he put it---by having this big excess value going for you.

-CHARLIE MUNGER, UNIVERSITY OF SOUTHERN CALIFORNIA (USC) BUSINESS SCHOOL, 1994

 

While the calculations of the intrinsic value and margin of safety are imprecise and fuzzy, they remain critical tasks in the Graham value investing system. As James Montier wrote:

 

Valuation is the closest thing to the law of gravity that we have in finance. It's the primary determinant of long-term returns. However, the objective of investment (in general) is not to buy at fair value, but to purchase with a margin of safety. This reflects that any estimate of fair value is just that: an estimate, not a precise figure, so the margin of safety provides a much-needed cushion against errors and misfortunes. When investors violate [this principle] by investing with no margin of safety, they risk the prospect of the permanent impairment of capital.

-JAMES MONTIER, THE SEVEN IMMUTABLE LAWS OF INVESTING, 2011

 

The golden rule of investing: no asset (or strategy) is so good that you should invest irrespective of the price paid.

-JAMES MONTIER, GMO LETTER, DECEMBER 2013

 

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Seventh Variable: Determining Whether the Quality of a Business Should Be Considered [132-136]

 

Ben Graham had blind spots. He had too low an appreciation of the fact that some businesses were worth paying big premiums for.

-CHARLIE MUNGER, DAMN RIGHT, 2000

 

Munger's approach to valuing a business is influenced in part by Ben Graham and in part by Phil Fisher. The importance of Phil Fisher to the evolution of Munger's thinking on the Graham value investing system is fundamental. For Fisher, wide diversification is essentially a form of closet indexing. He instead believed that an investor should focus on a relatively small number of stocks if he or she expects to outperform a market. Fisher preferred a holding period of almost forever; for example, he bought Motorola in 1955 and held it until 2004. Fisher also believed that a fat pitch investment opportunity is delivered rarely and only to those investors who are willing to patiently work to find them. Fisher felt that business cycles and changes in Mr. Market's attitude are inevitable. Unlike many other investors, Fisher assigned significant weight to the quality of the underlying business. For this reason, Fisher was able to outperform markets as an investor, even though he did not look for cigar-butt stocks.

An approach that incorporates the ideas of Fisher is very different from the approach of a Graham value investor like Seth Klarman. Both Munger and Seth Klarman want a margin of safety, which is a Graham value investing principle, but each investor chooses to calculate both intrinsic value and margin of safety in different ways. For Mnnger, the approach used by Fisher was clearly superior:

 

If I'd never lived, Warren would have morphed into liking the better businesses better and being less interested in deep-value cigar butts. The supply of cigar butts was running out.... The natural drift was going that way without Charlie Munger. But he'd been brainwashed a little by worshiping Ben Graham and making so much money following traditional Graham methods that I may have pushed him along a little faster in the direction that he was already going.

-CHARLIE MUNGER, KIPLINGER, 2005

 

The trouble with what I call the classic Ben Graham concept is that gradually the world wised up [after enough time had passed after the Great Depression] and those real obvious bargains disappeared.... Ben Graham followers responded by changing the calibration on their Geiger counters. In effect, they started defining a bargain in a different way. And it still worked pretty well. So the Ben Graham intellectual system was a very good one.

-CHARLIE MUNGER, USC BUSINESS SCHOOL, 1994

 

Buffett today is arguably more like Fisher than the 15 percent he once specified, but only he knows how much of my assertion is true. It was the influence of Munger that moved Buffett a considerable distance away from a pure Ben Graham approach. Their investment in See's Candies was an early example in which Berkshire paid more for a quality company. What Munger and Buffett found was that See's Candies had untapped pricing power which was able to increase its financial return in a very significant way. The two investors found after they bought See's Candies, they could regularly raise prices and customers did not seem to care. Munger calls this ability to raise prices and not cause a significant drop in sales "pricing power." Buffett said once, "More than 50 years ago, Charlie told me that it was far better to buy a wonderful business at a fair price than to buy a fair business at a wonderful price."8 What Charlie is talking about here is the idea that a business with superior quality bought at the right price can still be a bargain purchase consistent with the principles of the Graham value investing system.

Part of the reason this shift to Fisher's approach to valuing a business happened is that the sorts of companies that Graham liked to buy started to disappear the further away the time period was from the Great Depression. The other push toward Fisher's ideas came because of the success Munger and Buffett were having in markets. Because of their consistent and persistent financial success, Berkshire must put massive amounts of cash to work every year, and finding enough cigar-butt investments at that scale is an impossible task.

Unlike more pure Graham style investors, Munger believed his investing style had to evolve.

 

Grahamites ... realized that some company that was selling at two or three times book value could still be a hell of a bargain because of momentums implicit in its position, sometimes combined with an unusual managerial skill plainly present in some individual or other, or some system or other. And once we'd gotten over the hurdle of recognizing that a thing could be a bargain based on quantitative measures that would have horrified Graham, we started thinking about better businesses.

-CHARLIE MUNGER, USC BUSINESS SCHOOL, 1994

 

For Munger, not considering the quality of the underlying business when buying an asset is far too limiting.

 

The investment game always involves considering both quality and price, and the trick is to get more quality than you pay for in price. It's just that simple.

-CHARLIE MUNGER, DAMN RIGHT, 2000

 

We've really made the money out of high-quality businesses. In some cases, we bought the whole business. And in some cases, we just bought a big block of stock. But when you analyze what happened, the big money's been made in the high-quality businesses. And most of the other people who've made a lot of money have done so in high-quality businesses.

-CHARLIE MUNGER, USC BUSINESS SCHOOL, 1994

 

Munger believes the greater the quality of a company, the greater the strength of the wind at your back over the long term.

How do Munger and Buffett assess quality?

 

Leaving the question of price aside, the best business to own is one that, over an extended period, can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite---that is, consistently employ ever-greater amounts of capital at very low rates of return.

                  -WARREN BUFFETT, 1992 BERKSHIRE SHAREHOLDER LETTER, 1993

 

 Munger and Buffett are very focused on both the magnitude and persistence of the ability of a business to earn a return on capital. Return on invested capital (ROIC) is the ratio of after-tax operating profit divided by the amount of capital invested in the business. In short, how much a business earns on the capital employed in its business determines the quality of that business for Munger and Buffett. Growth of the business is, by itself, neither good nor bad. In the same I992 letter, Buffett wrote:

 

Growth benefits investors only when the business in point can invest at incremental returns that are enticing---in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value.

-WARREN BUFFETT, 1992 BERKSHIRE SHAREHOLDER LETTER, 1993

 

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"How does Munger account for risk when he buys an asset?" He will only invest if he strongly believes the current earnings are nearly certain to continue. While most other investors will adjust the discount rate for what they may believe to be greater risk, Berkshire wants essentially no risk as a starting point. In other words, rather than adjust the discount rate to account for risk, Munger and Buffett use a risk-free rate to compare alternative investments. They look for both conservatively determined fundamentals and a stable business history, which indicate to them that the current state of the business in question will continue. However, to provide a cushion against mistakes, they will not actually buy an asset without at least a 25 percent discount in intrinsic value (this discount is their margin of safety). [p. 154  Charlie Munger---The Complete Investor”]

 

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Warren Buffett stated the following:

 

Intrinsic value is the discounted value of the cash that can be taken out of a business during its remaining life.[p 224, The essays of Warren Buffett, 3rd edition]

 

Calculations of intrinsic value are necessarily imprecise and often seriously wrong. The more uncertain the future of a business, the more possibility there is that the calculation will be wildly off-base. [p 228 The essays of Warren Buffett, 3rd edition]

 

          Intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised. Two people looking at the same set of facts, moreover---and this would apply even to Charlie and me----will almost inevitably come up with at least slightly different intrinsic value figures. [p 224 The essays of Warren Buffett, 3rd edition]

 

Purchases of Berkshire that investors make at a price modestly above the level at which the company would repurchase its shares, however, should produce gains within a reasonable period of time. Berkshire’s directors will only authorize repurchases at a price they believe to be well below intrinsic value. [2014 annual report]

 

But in September 2011, Buffett announced that Berkshire would repurchase its shares at a price of up to 110% of Book Value. [p 185, The essays of Warren Buffett, 3rd edition]