Rethinking Margin of Safety

"Confronted with a like challenge to distill the secret of sound investment into three words, we venture the following motto, Margin of Safety."
-- Benjamin Graham


They've been called the three most important words in investing: margin of safety. For security analysis purposes, it describes the gap between intrinsic value and market value. There's an out-of-print book by renowned value-guru Seth Klarman titled after it that sells for over $1000.00.

Margin of safety serves two purposes: 1) to render "unnecessary an accurate estimate of the future." and 2) to guarantee "....a better chance for profit than for loss--not that loss is impossible."

Of course, this is an absurdity to adherents to the semi- and strong-form efficient market hypotheses, since all information is reflected in the stock price and no advantage can be gained through fundamental analysis. However, it is doctrine to savvy investors who believe the market is occasionally inefficient.

In a rebuttal to the wide acceptance of the efficient market hypothesis, Warren Buffett makes the following distinction: "Observing correctly that the market is frequently efficient, they went on to conclude incorrectly that it is always efficient. The difference between these propositions is night and day."

Does that mean that the margin of safety used by many is frequently illusory since markets are mostly efficient? If that's the case, are we often wishing for a margin of safety with the assumptions we use, and then unwisely believing those assumptions?

This idea can be extremely dangerous as investors make quick judgments about a company's worth and compare it to the value quoted in the stock market and say: "Eureka, I've found a bargain!" Even bright "value" investors, obsessive about correcting psychological errors, developing latticeworks of mental models, and avoiding the "herd" mentality, can fall prey to this. Imagine that. Demosthenes was dead on with these words: "The easiest thing of all is to deceive one's self; for what a man wishes, he generally believes to be true." If what at first glance appears to be a margin of safety, try to disprove yourself first.

Too good to be true?
A non-subprime-related company is trading at close to 20% of book value with all expectations to continue as a going concern. The balance sheet contains minimal goodwill and debt net of cash of $94M with a market cap of $113M and book value of $498M. One could say, we'll as long as they don't loose money year after year, there's a cushion, or margin of safety. But even property carried on the balance sheet for over $300M can't relieve the company of $3.6B in long-term leases. Unless the company improves its profit margin of (1.05%) and/or finds a way to renegotiate its leases, the margin of safety is zero since steady state earnings are impossible to extrapolate into the future. It's a tough business when you're a travel center that derives 80% of sales from fuel. TravelCenters of America (TA) may make changes and focus on its higher margin products and services, or fully integrate its recent acquisition, but until then, the margin of safety appears to be illusory.

Though the above example seems obvious. One must be cautious when estimating a margin of safety so that you're right more often than wrong. The trick is an understandable business model, conservatism in estimating, and transparency in the firm's financial disclosure.



Disclosure: None; Citation(s): Ben Graham, The Intelligent Investor;
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