Margin of safety 1 comments

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One of the concepts in investing that left the deepest impression on me in my early investing days and which I (would like to think) have internalised within my stock selection and general investment routine is the idea of margin of safety. Part of the reason is because it is the central tenet to Benjamin Graham's ideas on investment and which has been further promoted by Warren Buffett.

The other reason is that it is such a natural idea to me. As an engineer, I deal in margins of safety, or what we also call safety factors in our line, all the time. A component must be able to withstand several times the load it is designed to handle, because it should be able to handle contingencies. The more critical the application, the higher the safety factor required (eg. passenger lifts).

To take the engineering analogy a bit further, the safety factor is usually calculated by considering the various modes of failure that the component could undergo, for example by tension (pulling), compression (pushing), bending etc. It is an analytical process which requires insight into the various loads the component could be subject to, and consideration of the worst case scenario. The corollary when applied to investing is to consider various situations where the investment could go awry and whether one has factored it in his consideration of the investment case.

There are several approaches to ensure that the component does not fail and cause catastrophic engineering failure. One is through regular maintenance through which faults (such as cracks) can be detected; compare this with the need for regular monitoring of one's investment portfolio. Another is what is known as the fail-safe approach: even if the component fails, the system is still able to function (perhaps with parallel mechanisms). One parlays this idea to investment management by insisting on the availability of alternate exit strategies during stock selection such that should the main premise for buying the stock fail to materialise (say, one bought it in anticipation of a merger that didn't happen), it is possible to fall back on say, the strong fundamentals of the stock that will mitigate any disappointment manifesting big-time through a price collapse. This is one facet of margin of safety --- the existence of alternate exit strategies.

The most oft-mentioned approach to attaining margin of safety is through price management ie. buying cheap, low-PE stocks; this is just one method. I myself base my hotstocksnot picks often on the basis of the high stock valuations offering little margins of safety (eg. Raffles Education). Alternate approaches include the abovementioned close monitoring/portfolio maintenance approach, and the multiple exit strategies approach. On the portfolio management side, diversification is one way to apply the failsafe approach from a holistic view; failure of one stock will not cause such a big impact on the entire portfolio (while limiting upside too, of course). What one does not do also provides a margin of safety: not using leverage provides a margin of safety, a cushion that would be removed if he were to adopt margin financing or take overdrafts at high rates to buy stocks hoping to outperform the borrowing rates. Personally, I would rather buy high risk-high return stocks on my own money, than leverage on margin on lower-risk stocks. One can be a strong hand (ie. have holding power) on the stocks one pays for out of his own pocket, with the availability to exercise alternative exit strategies (and hence utilise the margin of safety) by holding for a longer period than anticipated/hoped; with borrowed money/margined stocks, the margin for error is smaller, and one's hand is weakened by the need to service debt or maintain margins should things move against him. True traders use leverage liberally; my approach however is to press aggressively for the medium/long term (weighting heavily towards growth stocks in areas and fundamental trends I favour) while maintaining a liberal margin of safety for the short term. That is in recognition of the fact that it is easier to be wrong over the short term than the longer term.

Of course, different brushes, different strokes. Others may have alternative means of finding their margin of safety. Returning to the engineering analogy, theoretical analysis of the margins of safety is not enough; product testing is the ultimate proof of strength. And so it is for investment portfolios; running through one up-and-down stock market cycle could be considered a proof test of one's portfolio management techniques and whether he has managed his risks well. Of course, whether the bullets might be exhausted after this entire cycle is another story altogether. It's better to be safe than sorry; hence it's better to be more conservative initially and tack on more margins of safety than less. After acquiring enough experience, one can then exercise "engineering judgment" and take on more discretionary risks ie. reduce margins of safety (and amplify potential upside).