In Investing 101, we touched upon the essential basics of Investing and the DCA mindset. In this article again like the previous one, I am going to be channelling a lot of the language of the giants of the Investing realm - specifically Graham, Buffett, Klarman, Greenwald and also Porter. But really, we already know a lot of the concepts and just need to pull them into our mental foregrounds.
So to start with, the operative keyword in the context of this article is 'Safety'. Which, by default puts us into a conservative investor's mindset as opposed to a speculative one. To paraphrase Graham, when Engineers design bridges, they typically do so to withstand up to 30 times the rated loads for these bridges. Bridges are designed to handle tanks when really being authorized to be used for passenger vehicles. This is safety. The stakes are too high to have a low margin of error given wear and tear and durability needs. This is exactly the mindset we need to get into when we think about our investment - is our investment built to last?
Picture the number of hours that an honors student would need to put in to ace his final exams - a full year's effort to handle any curve balls in the last couple of hours. At the beginning of the year, his best strategy is to be as prepared as he possibly can be. Same with our investments - is our investee company well prepared to handle the curve balls that the business cycle throws up - think competition, regulatory changes, price of raw materials, rising interest rates - the list goes on. This is one way to think of Margin of Safety.
The other way is to think from the investor's standpoint - in terms of the price paid for the investment. Value, like beauty, lies in the eyes of the beholder (his intrinsic value). What is valuable to me may not be valuable to you. This is the reason why buyers and sellers create a marketplace. In a group of rational people given the option to trade, every person will try to maximize his intrinsic value - maximize the value of the cards that he holds. Yet, without knowing what cards the other people hold, there is information asymmetry. Long story short, if my intrinsic value of my investment is $1, and I am able to buy it for say 60 cents, then my Margin of Safety (or margin of error) is 40 cents. I think investment is worth $1 because of my expectations of the value that I can derive from it. When the rest of the crowd is pricing it at 60 cents, then I build a 'moat' of 40 cents to be wrong about my expectations (my value system).
Moving away from preachy economics, lets embellish this further using a thought experiment. Say, you are an entrepreneur with some capital and want to buy a restaurant. What are the thoughts that will go in your mind? Given the location of the restaurant and a cuisine in mind, how many footfalls can I expect? Who is my target audience in this enterprise - my customers? Is it just one ethnic crowd that I am targeting? Can I build long lasting relationships for repeat business? Next, where am I sourcing the ingredients from - locally or some exotic destination? Can I build good relationships with my suppliers? Or can they squeeze me hard when the price of caviar skyrockets? Next, what is the kind of competition that currently exists or can exist in the future - how easy is it to open a new restaurant right across from where I am located? How will the dynamics change in that case? Finally, how important will I be for my customers in their larger scheme of things? Can I become obsolete overnight?
All we are talking about here are Porter's 5 forces - 1. Competition, 2. Threat of New Entrants, 3. Customer Power, 4. Supplier Power and 5. Threat of Substitution. An investor can evaluate how safe his investee business is within this framework. To be fair, for a typical restaurant, things do not look too good in this framework. Despite this, say I attribute a value of $100K to buy a restaurant that I like. This value is effectively derived from the economics that I can instill in the business once I take over. Meanwhile, this restaurant is available for $140K in the market. Either I am overly pessimistic, or the market (the seller in our case) is too optimistic. There is information asymmetry here. Should I shell out an additional $40K and buy the business? On the flip side, lets say the business is available for $60K. I have a Margin of Safety to be wrong by about $40K. If my expectations do not pan out, I can still sustain a loss of business value of $40K to break even. The wider the margin of safety, the deeper the moat, the taller the fences, the better.
There are still other kinds of Margins of Safety that we can consider - like liquidity (Klarman). Lets say, I want want to get out of the restaurant business in the future. Will I find enough buyers for competitive bidding? Or are there so few buyers in the market in general that I can unload the business only after marking down the price substantially? Things that we could take into consideration.
Notice that we haven't mentioned the word 'stock' even once. All we have to to mentally, is to replace the word 'stock' with 'business/ company/ enterprise/ restaurant' in our minds when we buy and sell. We have to treat our buy and sell decisions for stocks as if we are considering buying or selling the whole business (Buffett). If we have bought a stock with a good margin of safety, and the price reduces further, keeping all else constant, we should buy more of that stock since the market is giving us this free opportunity.
Finally, channelling Graham, we should buy our stocks like we buy our groceries. The problem is we do not haggle as much, and tend to get carried away by stories, hope, greed and emotions.
Next up - Intrinsic Value and Growth