A margin of safety, coupled with sustainable business advantages, makes for above-average investing. Microsoft's margin of safety has improved since its stock has declined, but the company's sustainable advantages are not quite as secure.
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Now that Microsoft (Nasdaq: MSFT) has fallen 50% from its high, is the stock a safer investment? One of Warren Buffett's favorite chapters in Benjamin Graham's classic book, The Intelligent Investor, is Chapter 20, which covers "Margin of Safety." Simply put, margin of safety measures the chance an investor has of making a respectable profit as opposed to the odds of suffering a loss. The margin of safety is dependent on the price of an investment. There is a high margin of safety (or great chance for profit) at one price, and a smaller margin of safety at a higher price. The worst investments grant zero margin of safety -- even over long periods, an investor will only lose money. Graham writes that the risk of paying too much for a high-quality stock, while being a considerable risk, is not the primary concern for the average investor. Instead, the greatest risk that most investors face is the risk of buying low-quality companies during favorable economic times, or boom times, when all stocks are rising. During these exciting times, new and obscure companies sell for high prices, granting investors little to zero margin of safety. When the bloom falls off the young flower, you're left holding a stem. Margin of safety is a mathematical tool. It dictates that an investor should not pay more for a business than the sum of all its future cash flows. Clearly, nobody knows what that sum will be, so it is an abstract mathematical tool. Thus, this tool is best used alongside a more objectively measured quality: sustainable advantages. Warren Buffett sums up investing in two sentences: "The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors." When you couple sustainable advantages with a margin of safety, you only buy businesses that promise continued, long-term value creation, and you buy the businesses at reasonable prices to earnings and free cash flow (while admitting that you usually pay a premium for the best companies). Warren Buffett's investments, from candy sellers to furniture makers, create tremendous, recurring amounts of cash flow every year with minimal additional investment, and they sustain profitability due to lasting advantages, be they geographic, distributive, branding, managerial, or, typically, a combination. However, the most important quality that investors should demand is a recurring sales base upon which the company can increase revenues each year with slight investment due to lasting advantages. Lacking recurring sales, a company must reinvent itself continually if it wants to grow, and, aside from the risks involved, it is not likely to build lasting advantages. This brings us back to Microsoft. Fool Rob Landley recently argued that Microsoft does not currently possess sustainable advantages in the way that Coca-Cola (NYSE: KO) does because Microsoft's core products are being undermined by the Internet. If we are evolving to Internet-access devices and away from full-fledged computers, will we need Microsoft Windows 10 years from now? Microsoft realizes this risk. Even as it defends its core operating system business, Microsoft is spending more of its money on Internet-based innovations, recognizing that the future is online. Online, however, Microsoft doesn't have the sustainable advantages that its operating system business has granted it. Microsoft's stock has a greater margin of safety following its decline, but the company's sustainable advantages are being attacked by the Internet, as well as by all the new or forthcoming computing devices from the likes of America Online (NYSE: AOL) and Palm (Nasdaq: PALM). We are years away from a Window-less society (if ever), but we are already in a period of shrinking advantages for Microsoft. This means that the stock market is less likely to award it the valuation multiples that it did just two years ago. The best investments are found when a stock's margin of safety is highly favorable and the company's sustainable advantages have remained entirely intact and are improving. We seek this caliber of investment in Industry Focus 2001. This ideal scenario occurs infrequently, however, so finding an agreeable mix of margin of safety and lasting sustainable advantages is the key to above-average investing. This holds true whether you're a Rule Maker investor, Rule Breaker investor, Drip user, or a Fool at large. Related Links:
The Intelligent Investor
Industry Focus 2001
Rule Maker Port: A Sustainable, Defensible Business
Motley Fool Research coverage of Microsoft
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