Businessman Investor

Touching base with the rational business psyche of stock market investors

Tuesday, September 20, 2011

The Margin of Safety Mentality—A Cornerstone of Value Investing

This is Part 2 of a Series. Go to Part 1: The Quantitative Principle of the Margin of Safety

The Margin of Safety as a Conservative Mentality or Attitude. It's all about managing your expectations, toning them down, and being realistic about them.
A different way of viewing the margin of safety principle is to think of it as a qualitative concept—an attitude or mentality, if you may. It is that mentality of being bias towards conservative approaches of intrinsic value appraisal which would guarantee protection from permanent capital loss but at the same time exposure to that bonus of rational potency of earnings.

It is that attitude towards using conservative assumptions even if you know the underlying business is much more capable. It’s somewhat intentionally downplaying the growth prospects not because you don’t believe the company won’t grow or boom, but that you’d rather bank on something that can be easily ascertained/achieved by the proven earning capacity of the business, and content yourself with that. Because while you know there’s much more into the investment, you’d rather not delve into complex forecasts, since, after all, if it’s really that good, actual earnings and free cash flows will take care of themselves.

And that makes it simple and decisive: you don’t have to worry about what a reasonable growth rate is; you don’t have to trouble yourself deciding which appropriate discount rate to use. You don’t even necessarily have to anticipate or expect anything grandeur at all. You just focus on what is already certain and being delivered at the present. So in the meantime, you’re just conscious about paying the best price for the most conservative scenario you’d hope for, and should the actual outcome turn out to be more than what you paid (which is most likely), then well and good. The key is managing your optimism—your expectations. The key is conservatism. You don’t necessarily have to be so precise about the exact, right, most reasonable price to pay. You just have to be approximately right about a deep bargain price, (and by experience, it’s indeed easy to tell what's cheap or not). Keep the estimation simple, and make it very conservative.

From Benjamin Graham's original words: "The function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future."

With that, I would like to share with you this partial transcript I did for that inspiring Alice Schroeder video I saw. I hope it inspires you as it has inspired me. Continue to Part 3: Handicapping, Compounding, and the Margin of Safety—Alice Schroeder’s Take on Buffett’s Approach

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