IFB21: The Benjamin Graham Formula for Finding a Margin of Safety

Intelligent Investor

Welcome to session 21 of the Investing for Beginners podcast. In today’s session, we are continuing our discussion of the Intelligent Investor and working through chapter 20. Again, this is one of the chapters highlighted by Warren Buffett as one of the most influential for him.

This is the chapter that opened my eyes with the discussion of the margin of safety. As a conservative guy by nature, this strategy struck home with me. There is much more to the chapter than this simple idea, check out our show notes to learn more.

  • Margin of Safety equals earnings yield minus bond yield
  • Amount of margin of safety depends on the market pricing
  • Using data over a period is critical
  • “Heads I Win, Tails I don’t lose that much.”
  • Roulette as an example of diversification
  • 2/3 or less of value is an adequate margin of safety
  • No good stocks, just bad prices.
  • Arithmetic is greater than optimism
  • “Have the courage of your knowledge and experience…..THEN ACT on it!”

Dave: These two chapters are Warren Buffett’s favorite of the Intelligent Investor, and they are chock full of all kinds of wisdom and great advice to help you invest better.

The first thing that he talks about is the margin of safety in this chapter, and Andrew I am going to let you chat about this for a second.

Andrew: So obviously Dave and I we love to talk about margin of safety, with an emphasis on safety. Benjamin Graham started that whole movement, which has been passed on through the generations. With many great investors put a big focus on margin of safety.

Everybody has their definition of what a margin of safety means to them; I know they certainly do. It can be valuation based, balance sheet based, and how Benjamin Graham defined it. I am surprised because I don’t hear it that much when other investors talk about it.

In the very beginning of the chapter, he talked about how he could find it as the earnings yield minus the bond rate. You think about the bond rate, and he’s talking about the interest rate that a bond will pay for that company. And the earnings yield is just the inverse of the price to earnings ratio.

With the price to earnings ratio, we like to see a lower price to earnings is better. Since the earnings yield is the same ratio just flipped, a higher earnings yield is better, and the higher the earnings yield, the more profitable you are.

How the applies to investors, theoretically and in practice. What essentially happens is represents the earnings of a company, and once the company receives its earnings it will pay it out in dividends, or they reinvest it into the company.

The two components of the earnings yield, if you take that earnings yield and subtract the bond rate you are left with this cushion that the company has of earnings. They either are going to use for dividends or reinvest in the company.

The higher that earnings yield is above the bond rate, the greater the margin of safety.

Because a bond is something that can be purchased through the market, it is that guarantee that the company is going to pay based on what their balance sheet is. You can think of it as a margin of safety, as a cushion because they have that many earnings over that kind of base rate.

If those earnings drop or things go wrong with the business, there is a worse case of accounting. This is a big way that Benjamin Graham focused on this chapter looking at a worse case. I’ve heard it referred to as in other books as it’s heads I win, tails I don’t lose that much.

If you’re calculating these margins of safety with big cushions as Graham talked about, you’re accounting for a situation where a company doesn’t do as well. If you have the cushion of earnings yield over the bond rate then even if the company does poorly. You can still get a decent return on your investment.

If the return is great, you see that difference, and you’ll have the higher return.

Dave, I think that the one thing that I would add to what you were saying. I mean, you made a bunch of great points. The cushion that he talks about, and for me when we are talking about a margin of safety, Andrew and I are always looking for the safety part of the equation.

The reason why we are doing that is that when you are calculating an intrinsic value for a company, or looking at the financials of a company and trying to determine what you think the company is worth.

You are always looking for a cushion in case there is an error in your calculations. And I am not a mathematician, and I know that Andrew is not. The chance of making a mistake, it’s possible and when I am looking at this formula. I am trying to find as big a cushion of safety as I can so if I do make a mistake that I am not going to get burned so badly.

Monish Pabrai was the gentleman you were referring to earlier when you said: “Heads I win, tails I don’t lose that much.” That is his take on the margin of safety, I buy into that, and that is something that attracted me to value investing, was this concept of margin of safety.

When I read this book the first time, it struck me as exactly what I am looking for. I am by nature am a conservative guy and when I am looking to invest in a company using my hard-earned money. I am looking for an ability to make money on my investment, and also to minimize my losses.

As Andrew has said many, many times, which I think is very astute, it’s more important to minimize your losses sometimes than to worry about making these monstrous gains. That is really where you are going to win in the long run.

We’ve talked many times in the past about if you lose big on investment, it can take you years, if not decades to recover from that. A margin of safety allows you the ability to invest with confidence and be able to go to bed at night and sleep comfortably without about having to worry about. Did I make a mistake on this? Graham, to me this was the most important chapter in the book for me personally.

This highlights what I was looking for, when I was looking for investment guidance, this book struck me.

Andrew: I thought it was interesting too because as a value investor a big part of finding the value is tied up in assets not easily removed. Finding the net asset value, book value, price to book ratio, he has a big reference to that. There is a big emphasis on that I thought that it was interesting that margin of safety chapter only referred to earnings.

If you can combine the two, as Graham does, then it can be a very powerful because while you’re maximizing for a discount with a price to book ratio, and getting a great price. Obviously, the earnings yield has something to do with that as well.

If it is an inverse of the price to earnings ratio, it is very dependant on where the price goes. To have earnings as a key component as well, which I think is key as well. Something that can easily be overlooked.

Another point that is kind of related that Graham made was the scale or the amount of margin of safety that he would see throughout the market will depend on what the market is doing. If it is a bull market, you will see it be much harder to find a margin of safety or that margin of safety won’t be as huge.

What he said specifically was “during times where things are very prosperous people are making money and buying any old stock and not having any problems getting returns.

To be careful about low-quality business, obviously, you want to be careful about the price you pay as well. He said that low-quality businesses are going to do worse for you than a high priced stock.

That doesn’t sound intuitive to me, and it’s not something I would’ve thought about too much. The big stories, you want to be careful when there is a bubble, those stocks tend to take the headlines, crash the hardest. Also look out for companies that may be going up in price, and their earnings aren’t there, growth or the balance sheet is getting taxed, in the sense that there is more debt accumulating.

Then he talks about the roulette wheel when you are looking at stocks like that make sure you look at the health of the business and just because the stock is cruising up high, don’t let that make you feel like a margin of safety that isn’t there.

That can burn you, and that is something that Graham has seen, and other investors have seen along the way as well.

Graham talks about this idea of the roulette table and how it really can relate to both the margin of safety and diversification.

If you go on the roulette table and you put $1 into each number, the way the casino has set up the game is you could do that, but the house is going to win because of the way the odds are structured. If you make enough bets, over the long term, the house is going to win.

Graham talks about how with diversification you have a bunch of stocks with a margin of safety and because you’re making these mathematical decisions and the margin of safety is based on the cold, hard facts.

You are essentially setting the odds in your favor, by combining that with diversification what you are doing is instead of making great bets. If you are on the roulette wheel and the number 7 and 13 have great odds, compared to 6, 8, 10.

You can put all your money on seven, just because the odds might be in your favor. It’s not a good gambling choice; it’s not a good investment. But if you’re the type of gambler that sees 7, 11, 13, 17, there are maybe 10 or 20 numbers that have average odds then you spread your bets along those favorable odds, and then over the long term, you are beating the house.

That is the same concept with investing, and that is why Graham says that diversification combined with a margin of safety can be so powerful, because you are essentially making these mathematical calculations, and seeing that these particular stocks have higher mathematical odds of doing well.

Either having their cushion absorbed, so that they will keep having a great return regardless, or having superb returns. And by spreading them out, you are improving the chances, and over the long term, your chances are going to be better, than an investor who is speculating.

Again, he goes back to the metaphor of speculating, but somebody who is trying not to make a mathematical computation, but more of an optimistic, emotional speculating.

Dave: He talks a lot about the odds, and he kind of actually puts a number on it. I’ve heard a wide ranging different numbers, and I have different numbers that I look at. One of the things that I read somewhere that Warren Buffett when he first started out was looking for a 50% margin of safety.

Depending on where you are in a cycle of bull versus bear markets, that may provide you an opportunity to do that kind of thing. I look for around 25% or better if I can find it, depending on the quality of the company.

It depends, and there are all kinds of ways that you can go about doing that. In finding the intrinsic value is kind of key for me to try to find what I think the company is worth versus what it is selling for.

Our good friend Mr. Market, which we talked about last week. If he comes at you and you think that the company is worth $25 and he is offering it to you for $50, then you may or may not want to pass on that.

There are all kinds of different ways to calculate that intrinsic value, and he talks about the arithmetic versus the optimism, and I think that is a great way of doing it because if you just look at the numbers, the numbers are not going to lie.

The margin of safety works in with trying to create a cushion so in case your calculations are incorrect or off a little bit you don’t get creamed in the market. And if they are incorrect then at least you have a buffer to help you get through it.

And you are not just going on the fact that you like this company because you use their product and you think it is the greatest thing since sliced bread.

The other thing he talks about is the no good or bad stocks, just bad prices. Andrew and I like to make Amazon our little whipping boy, and some other companies like Snapchat, Facebook, among others.

Right now, Andrew and I have never said that they weren’t good companies, I love Amazon, I use it all the time. As does my wife, perhaps a little too much, if you know what I mean. The price you would pay for it is just obscene, and it’s really expensive.

Warren Buffett has mentioned numerous times that he thinks that Jeff Bezos is the best manager he has ever seen, or among the best. But you’ll notice that he is not buying his company, and that is for one simple reason, way too expensive for what it is worth.

And it has nothing to do with the actual price itself, but rather the valuation behind the price. To pay $198 for $1 of earnings is just absurd and nobody in their right minds should do that. If you are looking to the long-term horizon, then you are just setting yourself up for a fall because it can only go down over the long-term, and it will.

This illustrates what Graham was referring to when he mentioned there are no good or bad stocks, just bad prices. The price of Amazon, in particular, right now is just too high versus what it is worth and this makes it an extremely risky proposition for a beginning investor.

That doesn’t mean that someday in the future that the P/E ratio will normalize and come back to earth. Which at that time may make it a great investment for the future. Right now, for me, it is not a good investment, solely because there is absolutely no margin of safety and if it falls, I will lose everything.

As a value investor, that is rule numbers one, don’t lose money. Rule number two is don’t forget rule number two, courtesy of Warren Buffett.

These are the thoughts that I picked out of this part of chapter 20 that I thought appropriate for what we were talking about.

Andrew: I love it, and such a big and important point something that definitely shouldn’t be overlooked.

In the end, he has a couple of rules to kind of close out the chapter. I picked out one that I thought was a great one that we should just end on.

He says “have the courage of your knowledge and experience.” Do the readings, understand what he talks about, make the margin of safety calculations and then just act on it. Forget about if you’re doing the most popular opinion if your jumping into these stocks that the media is saying is in a down cycle.

You’ve made the margin of safety calculations, and as he said, have the courage of your knowledge and experience and just do it.

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