Anytime the word price tiptoes onto the Drip Port scene, our minds almost immediately turn to the issue of margin of safety. Folks who have been investing on their own for any length of time may have developed a very specific notion regarding exactly what margin of safety means. In our minds, however, these three little words can be interpreted by different investors in different ways.
As far as investing principles go, margin of safety has been with us for a long time. We'll lay off delving into a full-blown historical examination of the concept. However, be aware that numerous successful investors over the years have incorporated margin of safety into their own investing philosophies and have made money. In fact, some have made a ton of money. So, to put it playfully, we believe it to be a topic that is deserving of at least a couple hundred words in a backwater online investing column.
According to the late investment thinker Benjamin Graham, margin of safety is distinct and discernible. It's not just so much philosophical hooey. "The margin of safety is always dependent on the price paid," Graham said in his classic book, The Intelligent Investor. Later in this book he goes on to state, "The investor's concept of margin of safety... rests upon simple and definite arithmetical reasoning from statistical data." This thinking follows along the same lines as Galileo's assessment that scientific realities are often revealed only with the help of math, although we're pretty sure that Graham and Galileo never met.
In essence, what Graham is getting at is the idea that margin of safety can -- and should be -- calculated. Using historically relevant information from a firm's financial statements (Graham himself preferred to look at the balance sheet) an investor should be able to determine independently at what price a stock or other security provides an appropriate margin of safety and ensures a sound investment.
The underlying theme of all this makes boatloads of sense to us. After all, even our limited investing experience with this portfolio has proven to us that the price paid is more often than not the most important determinant of long-run returns. However, our investing methodology has prompted us to be intellectually flexible when it comes to how we fit the concept of margin of safety into our investing process.
Just to be clear, this portfolio certainly does pay attention to the price paid when making its monthly investments. However, we accept the fact that investors have their own ways of doing things. Other Drippers may be less price-sensitive, especially those that dollar cost average into the same stocks month after month through a service such as an Automated Clearing House (ACH) account or through their own discipline.
Such a strategy is not some kind of inexcusable investing sin, in our view, because the dollar cost averaging process by itself is a modified but very effective corollary of Graham's take on margin of safety. If you buy more shares of a stock when its price is low and less when its price is high, there is a natural downward bias toward a low overall cost basis over time. Again, that's reality being revealed by math. It's probable that Graham would not have completely agreed with this investing style, but Galileo might have.
Another way that this portfolio uses margin of safety in its investment process has to do with the business characteristics we demand of our holdings. Our proclivity for identifying and investing only in businesses that have prospects for achieving high returns with little capital needs, benefit from strong competitive advantages, and are run by able and proven management can be considered, in a manner of speaking, as an additional margin of safety. This is in contrast to Graham's belief that margin of safety is always price-dependent. However, we like the probabilities that our reasoning will be correct.
The use of the term "probabilities" here is not accidental. In our view, margin of safety is an effective means of dealing with risk -- or the chances that something really, really bad will occur at some unknown point in the future. While Graham's original notion of margin of safety deals with what can be considered "price risk," our extended definition deals with what can be loosely called "business risk," for lack of a better term.
While hard to quantify, business risk is very real. (For an example, just look at our ongoing heartaches with Campbell Soup.) If we invest in companies that possess all of the desired traits listed above, we believe we swing the probabilities of avoiding a business risk-related catastrophic loss in our favor. This acts in the same fashion as Graham's margin of safety, which had the purpose of swinging the probabilities of avoiding a price-related catastrophic loss in an investor's favor. For the modern-day Galileos out there, business risk is more investing art than investing science. Relying on math here is hard. (Or to be more precise, Jeff and I are not smart enough to figure out how to use math properly in this situation.)
We probably will spend more time in future columns discussing the issues of margin of safety, probabilities, and risk, especially the yet-untouched issue of "analyst risk." (See our Campbell Soup experience again.) Until then, be flexible in your Drip investing... and be Foolish!
More reading on Ben Graham and margin of safety:
