The Intelligent Investor: “Margin of Safety” as the Central Concept of Investment

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intelligentThis is the twenty-first (and last) in a weekly series of articles providing a chapter-by-chapter in-depth “book club” reading of Benjamin Graham’s investing classic The Intelligent Investor. Warren Buffett describes this book: “I read the first edition of this book early in 1950, when I was nineteen. I thought then that it was by far the best book about investing ever written. I still think it is.” I’m reading from the 2003 HarperBusiness Essentials paperback edition. This entry covers the twentieth and final chapter, which is on pages 512 to 524, and the Jason Zweig commentary, on pages 525 to 531.

We’ve reached the end of the trail.

This chapter closes out The Intelligent investor by discussing the true message behind the book: companies that provide a great value are quiet, solid, and able to resist competition. They just pay out their dividends and keep doing what works.

Graham sums this up in one concept: the “margin of safety.” Simply put, it’s the idea that a company has established such a stable business that the company can succeed through many environmental changes. The economy goes up or it goes down – either way, the company is safe and stable. Competitors come and competitors go – the company survives. Management changes – the company rolls right through it.

Companies that have established themselves with such steadiness are the real value stocks. Quite often, companies like this are actually seen as boring (particularly if the company’s business is not in an exciting sector) and thus are often ignored in the “hype” talk on CNBC and the like. That means there aren’t a whole lot of buyers, even though the company is very strong, and that results in an undervalued stock. You buy it for cheap, ride the stability, and collect dividends along the way.

Sounds like a great plan to me.

Chapter 20 – “Margin of Safety” as the Central Concept of Investment
A single quote by Graham on page 516 struck me:

Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.

Basically, Graham is saying that most stock investors lose money because they invest in companies that seem good at a particular point in time, but are lacking the fundamentals of a long-lasting stable company.

This seems obvious on the surface, but it’s actually a great argument for thinking more carefully about your individual stock investments. If most of your losses come from buying companies that seem healthy but really aren’t, isn’t that a profound argument for carefully studying any company you might invest in?

Graham takes this point a step further, arguing that diversification is strongly correlated with margin of safety. In effect, Graham states that you introduce some additional margin of safety into your portfolio when you own a widely diverse array of value stocks that each have significant margin of safety.

Graham’s final note is pretty simple: investors get in trouble when they abandon their basic principles in the heat of the moment. One must approach investing with a set of fundamental principles and not abandon them in the heat of the moment.

Commentary on Chapter 20
Zweig closes out this final chapter by arguing that psychology is a major part of investing, one that many people overlook in the rush to find the big bargain. He goes so far as to argue that people are the primary risk in their own investing – poor decision making and abandonment of principles results in far more loss than an investment gone wrong.

Zweig actually ties this to Pascal’s wager, a famous suggestion by the French philosopher Blaise Pascal in which he argues that, since God’s existence cannot be determined through reason, one should behave as though God does exist, since living in that way (as opposed to living as though God does not exist) provides much more gain than loss. Similarly, since one cannot prove what will happen in the future with investments, we’re better off living by our investing principles than playing it by ear.

This is the final entry in the book club reading of The Intelligent investor. I hope you enjoyed it as much as I did.

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18 thoughts on “The Intelligent Investor: “Margin of Safety” as the Central Concept of Investment

  1. “Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.”

    I would say this means exactly what it says. In bull markets, stocks as a whole are up – including lower quality securities. In bear markets, lower quality securities might be even more depressed than the market as a whole, and might represent some sort of bargain. So the worst thing you can possibly buy are low-quality securities in a bull market.

  2. An excellent series of posts!

    I look forward with some anticipation to see what you roll out next Friday. Will it be a new book or something completely different?

  3. I have just started to read this book and would like to follow along with your posts. Can you post links to all 21 posts in this series either here in the comments, or as a separate post?

  4. @ Dave – I have the new edition of security analysis with new commentary from Seth Klarman, et al., but I haven’t had time to read it lately. I’m looking forward to it – it’s a pretty big book.

  5. It’s well known that Buffett considers this THE must-read investment book.

    Less well known is that Buffett has also often said that much of the value of this book is contained in chapters 8 and 20.

    Thus, today’s review represents the absolute cream of the crop in general investment wisdom.

  6. Hi all,

    I thought that since this is such an important book and such an important concept to grasp correctly to be an intelligent investor, i would add some constructive words to what has been written here.

    My issue is with the following summary …

    “Graham sums this up in one concept: the “margin of safety.” Simply put, it’s the idea that a company has established such a stable business that the company can succeed through many environmental changes. The economy goes up or it goes down – either way, the company is safe and stable. Competitors come and competitors go – the company survives. Management changes – the company rolls right through it.

    Companies that have established themselves with such steadiness are the real value stocks.

    This to me is completely missing the point that Benjamin Graham makes quite clearly. What I believe is being described above is finding a company that has a sustainable competitive advantage. This is what Buffet, Munger and others (such as Lynch) have really focused heavily on. However “Margin of safety” is a separate, albeit related, and very concrete concept. It is that the investor places a valuation on a company and then pays less than that valuation by a substantial margin (of safety). This concept can be applied to a diverse array of investments and the method of arriving at a valuation can vary too. Put another way, a super solid franchise with all of the competitive advantages alluded to, if selling at an inordinately high price, is a *BAD INVESTMENT*. This is exactly the point Graham is trying to make, so i believe this is really a key. Some value investors hunt down really deep value NTA type plays where the company is going broke and liquidation is almost guaranteed. They simply demand a much larger margin of safety and possibly diversify a little more. Another issue I have is the conclusion that Graham is implying that wide diversification is in effect a margin of safety. It is not, so much as diversification gone too far can draw an investor’s attention away from objectively arriving at a valuation and trying to really understand the nature of a business assets and liabilities. Sure some diversification coupled with margin of safety is probably a risk mitigation bonus, but mixing the concept of margin of safety with diversification is confusing the issue.

    Weather you buy a house, a stock, a bond or some gold… the fundamental principle of margin of safety can be applied, and it is simply to put a valuation on the asset, then play less than this valuation by some safe margin. Period.

    Indeed, Graham actually favors the kinds of valuations where investors do not try to place too much value on future growth (e.g. the long term competitive advantage / moat type investing) and prefers to look at current earnings as if they remained constant into the future. Also he places emphasis on not using current years earnings only but also on average of previous few years. All this is to be as conservative as possible (e.g. more margin of safety).

    Please don’t get me wrong, i’m not saying that looking for a durable competitive advantage is wrong, i’m just saying that the concept of margin of safety is more holistic than looking for this particular quality. Also often these moats are used within valuations to project earnings *growth* into the future, and I think this has stung many of us. Also another thing Graham does not really push.

    Regards,
    andyc

  7. Interesting stuff, as alwasy. The comparison to Pascal’s wager is interesting, and the lessons for investors are pretty clear. Good series, all the way through.

  8. Really top stuff Trent, u captured the concept of margin of safety splendidly. Dissapointed as I am that u ignored my last effort to improve the information contained on your site. It won’t happen again

  9. Thank you for great review of a classic. I normally don’t read your blog, but these chapter-by-chapter book reviews are clear, concise, and informative for readers of all levels. Hope you will do similar reviews in the future. Agreed with alvanson, would be great if you could post all chapters in one link.

  10. Thanks for posting Trent, maybe if i’m wrong someone can at least rebuke me now. Keep up good work :)

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