My views on the market, tech, and everything else

Charlie Munger on Margin of Safety (the Fourth Essential Filter)

“No matter how wonderful [a business] is, it’s not worth an infinite price. We have to have a price that makes sense and gives a margin of safety considering the normal vicissitudes of life.”  Charlie Munger http://www.psyfitec.com/2009/10/buffett-and-munger-on-bbc.html

Are you an Investor or a Speculator?

Anyone who wants to understand Charlie Munger must understand this:  If you are buying a share of stock, the investing process is the same as if you were buying a business since a share of stock is just a partial stake in a business.  For example, a share of IBM stock is just a small share of IBM’s overall business.  If you do not follow this approach in Charlie’s view you are a “speculator” and not an “investor.”

Charlie is a firm believer in what Benjamin Graham once said:

“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return.  Operations not meeting these requirements are speculative.”  http://en.wikipedia.org/wiki/Benjamin_Graham

Buffett has his own version:

“If you’re an investor, you’re looking on what the asset is going to do, if you’re a speculator, you’re commonly focusing on what the price of the object is going to do, and that’s not our game.” http://en.wikiquote.org/wiki/Warren_Buffett

The objective of a “speculator” is to make predictions about the psychology of large masses of people, which if you are both smart and experienced is a sobering thought.   How good are you at predicting what people will do once assembled into a mob?  The big danger here is that you just end up following the crowd and doing what Munger talks about here:   “Mimicking the herd invites regression to the mean (merely average performance).” http://www.scribd.com/doc/68337347/Charlie-Munger-Investment-Principles  If you are not going to do any better than average, what’s the point of doing any works to outperform an index fund (more on this on the next post?  Seth Klarman writes:  “If you can’t beat the market, be the market.” (Margin of Safety,  p.  212).

As an example, people who “day trade” stocks using goofy charts and other voodoo-like practices are speculators.  You will hear them talk about how the market “behaves” rather than what the value of a given stock may be. To guess about market “behavior” based on a chart is just that: a guess!  Speculators are focused on price whether it may be an old baseball card or share of stock.  Seth Klarman writes in his book Margin of Safety: “Technical analysis is based on the presumption that that past share prices meanderings, rather than underlying business value, hold the key to future stock prices.” Talking heads on cable TV barking out recommendations to buy X and Sell Y as if they were on ESPN Sports Center are speculators/entertainers and are not investors.  People who trade on inside information are actually investors, albeit ones that may go jail if caught.  Some people who call themselves traders only succeed in doing so because they have better information or are taking the other side of trades with “muppets” being sold down the river via false advice.

Keynes put it this way:  “Speculation:  The activity of forecasting the psychology of the market.”  Keynes went on to say the speculator must think about what others are thinking about, what others are thinking about the market, [repeat].   In a Keynesian beauty contest judges are told not to pick the most beautiful woman but instead to pick the contestant they think the other judges will choose as the most beautiful.  The winner of such a contest may be very different than the winner of a traditional beauty contest.  Keynes wrote about such a contest:

“It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.  And there are some, I believe, who practice the fourth, fifth and higher degrees.”  General Theory of Employment Interest and Money, 1936.  http://en.wikipedia.org/wiki/Keynesian_beauty_contest

Much of what went on in the IPOs of Facebook, Zynga and Groupon was a Keynesian Beauty contest:  people were trying to guess what other people thought about what other people thought [repeat] about when these stocks would correct with everyone trying to get out just in time.  Facebook, Zynga and Groupon investors were trying to “time” when the stock would fall even though the clock had “no hands” and so it was impossible to “time” the exit.

Mispriced Bets

Charlie Munger’s best essay and arguably the one that made him most famous is entitled:   “A Lesson on Elementary, Worldly Wisdom as It Relates to Investment Management & Business” and it can be found at http://ycombinator.com/munger.html   In this wonderful essay (very much worth reading in full) is a long passage which includes this language:

“The model I like—to sort of simplify the notion of what goes on in a market for common stocks—is the pari-mutuel system at the racetrack… Everybody goes there and bets and the odds change based on what’s bet.  That’s what happens in the stock market.

Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so on and so on.  But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then it’s not clear which is statistically the best bet using the mathematics of Fermat and Pascal….”   http://ycombinator.com/munger.html

It is worth pointing out that value investing inherently is at odds with the “efficient market hypothesis” (more on that in the next blog post).  In the real world, sometimes stocks are underpriced and sometime they are overpriced.  To say that Facebook, for example, had an “efficient” price the day it went public and then a far lower price a short time after the stock substantially dropped in price is to defy common sense.  During the first few months Facebook had a value that did not change very much, but the price changed a lot.  Price does not always equal value.  Anyone who invested through the Internet bubble in 2001 as I did and who still thinks markets are *always* efficient is bonkers.

Business Necessarily Involves Risk, Uncertainty and Ignorance

When you make an investment the laws of probability apply since the decisions involves risk, uncertainty and ignorance (more on this in a later post too, but to jump ahead read: http://www.hks.harvard.edu/fs/rzeckhau/InvestinginUnknownandUnknowable.pdf).  If you are making “bets” on stocks and “the house” has the odds in their favor you are gambling/speculating.   If you have the odds in your favor you are instead “investing.”   It should be not a surprise that many successful investor and business people are experts at poker and bridge. Some of them, like Charlie Ergen, were once card counters in Las Vegas. Successful business people don’t really gamble since their *big* bets happen when the odds are substantially in their favor.

Many people make the mistake of assuming that buying a quality company ensures safety.  Samsung may be a quality company with an attractive business, but that alone is not enough since the price you pay for a share of stock matters.  Facebook may be an important company with lots of page views to put advertising on, but it is not worth an infinite price.  Howard Marks puts it best:

“Most investors think quality, as opposed to price, is the determinant of whether something’s risky. But high quality assets can be risky, and low quality assets can be safe. It’s just a matter of the price paid for them…. Elevated popular opinion, then, isn’t just the source of low return potential, but also of high risk.” http://ivanhoff.com/2012/12/27/high-quality-assets-can-be-risky-and-low-quality-assets-can-be-safe/

Similarly, just because the price of share of stock in a company is beaten down from formerly high levels does not make it “safe” to buy.  As an example, HP is way off its value of a few years ago, but that alone does not necessarily make the purchase of the stock “safe” in terms of a Margin of Safety.

The “Margin of Safety” concept is about making it likely that you have the odds significantly in your favor by trying to find a substantial cushion in terms of the odds.  Munger does not believe that this happens very often, particular when it is in your Circle of Competence and the other investing filters are in place.  Since finding a significantly mispriced bet does not happen very often, when it does happen you should bet *big*.  Charlie believes that this means most of the time an investor should be sitting on their “rear end” reading and talking to people.  Munger has said:  “Investing is where you find a few great companies and then sit on your ass.” http://wealthymatters.com/2011/02/12/charlie-mungers-quotes-mungerisms/    Buying and selling stocks for its own sake (e.g., to stay busy)  is a very bad idea.

“It’s not given to human beings to have such talent that they can just know everything about everything all the time. But it is given to human beings who work hard at it – who look and sift the world for a mispriced bet – that they can occasionally find one. And the wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time they don’t. It’s just that simple.”  http://ycombinator.com/munger.html

One truism about investing is this: for you to find a significant mistake, someone else must be making a mistake too.  Seth Klarman writes:

“Investors operate within what is for the most part a zero-sum game. While it is true that the value of all companies usually increases over time with economic growth, market outperformance by one investor is necessarily offset by another’s underperformance.” http://budfox.blogspot.com/2012/11/seth-klarman-goes-nuts-on-fed-in-his_6.html

In other words, when you are investing you are searching for *significant” mistakes made by others.  And when you find a *significant* mistake, you bet big.

Everyone Makes Mistakes (No Exceptions).

The first post in this series was about the inevitable mistakes people make.  Everyone makes mistakes.  If you think you don’t make mistakes, you are in dire need of psychological counseling on that issue alone.   Donald Trump would be one example of someone who needs psychological help on this point at least.

What you are trying to do when making an investment is to find a mispriced bet.  What Margin of Safety is all about is finding a *significantly* mispriced bet.  When you look at the current price of a stock like Apple, do you see a significant mistake being made by the market in terms of the price it is offering you at that moment? Charlie puts it this way:

“[Ben Graham developed this] concept of “Mr. Market.” Instead of thinking the market was efficient; he treated it as a manic-depressive who comes by every day. And some days he says, “I’ll sell you some of my interest for way less than you think it’s worth.” And other days, “Mr. Market” comes by and says, “I’ll buy your interest at a price that’s way higher than you think its worth.” And you get the option of deciding whether you want to buy more, sell part of what you already have or do nothing at all. To Graham, it was a blessing to be in business with a manic-depressive who gave you this series of options all the time.”  http://ycombinator.com/munger.html

When the investor faces the challenge of investing he or she faces risk, uncertainty and ignorance. Seth Klarman writes:

“A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world.” http://www.marketfolly.com/2012/04/notes-from-seth-klarmans-margin-of.html#ixzz2FqyYTIon

The bad news for some people in all of this is that investing is hard.  But the good news is also that investing is hard and if you have the right temperament and are willing to do the necessary work the process can be fun.  As Charlie has said:

“If (investing) weren’t a little difficult, everybody would be rich.” http://www.wiley.com/WileyCDA/WileyTitle/productCd-0471446912,descCd-tableOfContents.html

To better deal with inevitable mistakes we all make as human beings, Charlie believes that you should have built into the process a “margin” of sufficient size which ensures that even if mistakes happen the outcome will be “adequate” as Ben Graham describes.  Graham called this a “Margin of Safety.”  When you are thinking about buying shares of, for example, Cisco, do you see a value of those shares which is 20-25% less than actual value?  If you see a significant discount from value in the current price of an investment, you have a Margin of Safety.

Margin of Safety has evolved since Graham

What Graham did in applying this Margin of Safety concept in his era was quite different than the way Buffett and Munger use it today.  In the aftermath of the depression Graham was spending most of his time looking for companies “worth more dead than alive.” These “cigar butt” companies were more common at that time, but as years passed and they more or less disappeared.  Buffett, encouraged by Munger, began to apply the same principle to companies that were of high quality and the process worked just as well.  Munger:

“Ben Graham followers… started defining a bargain in a different way. And they kept changing the definition so that they could keep doing what they’d always done. And it still worked pretty well.”   http://ycombinator.com/munger.html

Munger believes that process in a financial transaction is similar to processes that exist in engineering:

“In engineering, people have a big margin of safety. But in the financial world, people don’t give a damn about safety. They let it balloon and balloon and balloon. It’s aided by false accounting.  http://www.tilsonfunds.com/motley_berkshire_brkmtg03notes.php3

If you are building a bridge as the designer you want to make sure that it is significantly stronger than necessary to deal with the very worst case.  Buffett wrote once:  “When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 trucks across it.  And the same principle works in investing.”  Charlie thinks investing should be similar.  The first rule of investing is:  don’t make big financial mistakes. The second rule is the same as the first rule.

The size of the minimum Margin of Safety should vary with the magnitude of the risk involved. In his fantastic new book Michael Mauboussin writes:

“As Graham noted, the margin of safety ‘is available for absorbing the effect of miscalculations or worse than average luck.’ The size of the gap between price and value tells you how you’re your margin of safety is. As Grahaham says, the margin of safety goes down as the price goes up. In other words, make you margin of safety as large as possible.” The Success Equation at 169.  http://www.amazon.com/The-Success-Equation-Untangling-Investing/dp/1422184234

In terms of the size of the Margin of Safety, Munger and Buffett like the amount to be so big that they need not do any math other than in their heads:

Munger:  “Warren often talks about these discounted cash flows, but I’ve never seen him do Buffett:   “It’s sort of automatic. It ought to just kind of scream at you that you’ve got this huge margin of safety.” http://wealthymatters.com/2011/02/12/charlie-mungers-quotes-mungerisms/

Munger talks once about the concept of Margin of Safety in describing Buffett’s one time mentor Benjamin Graham in this way:

“Graham had this concept of value to a private owner—what the whole enterprise would sell for if it were available. And that was calculable in many cases.  Then, if you could take the stock price and multiply it by the number of shares and get something that was one third or less of sellout value, he would say that you’ve got a lot of edge going for you. Even with an elderly alcoholic running a stodgy business, this significant excess of real value per share working for you means that all kinds of good things can happen to you. You had a huge margin of safety—as he put it—by having this big excess value going for you.”  http://ycombinator.com/munger.html

Since nothing is certain in investing, the best approach is to think probabilistically.  Michael Mauboussin says it best:

“Margin of safety can be restated as a discount to expected value. Expected value is a function of the weighted probability of potential outcomes.”   http://people.stern.nyu.edu/adamodar/pdfiles/eqnotes/marginofsafety.pdf

“[One] way to cope with noise is to think probabilistically. The basic idea is to intelligently consider value outcomes and their associated probabilities. These probabilities and outcomes allow you to determine an expected value, and you want to buy at a substantial discount to that value. That discount is what Ben Graham would call “margin of safety.” His message about margin of safety is just one of Graham’s enduring lessons.”  http://seekingalpha.com/article/163743-interview-michael-mauboussin-chief-investment-strategist-legg-mason-capital-management


In determining the value of a business people make many different mistakes.  One reason why so many mistakes are made is that both a business and an economy are unpredictable complex adaptive systems (more on that later).  Another reason is that promoters can tell tall very convincing stores and many investor buy into the false narrative to their detriment.

The starting point in the process is setting a valuation.   At his core, Munger believes:

“You must value the business in order to value the stock.” http://www.valuewalk.com/charlie-munger-page/

In setting a value Munger and Buffet don’t swallow the stores of promoters that sing songs and tell tall tales about EBITDA and non-GAAP “earnings.”  They like genuine free cash flow.  Munger:

“There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested — there’s never any cash. It reminds me of the guy who looks at all of his equipment and says, “There’s all of my profit.” We hate that kind of business.” http://www.tilsonfunds.com/motley_berkshire_brkmtg03notes.php3

Warren Buffett describes the valuation investing process in this simple way:

“Though this … cannot be calculated with engineering precision, it can in some cases be judged with a degree of accuracy that is useful.  The primary factors bearing upon this evaluation are:

     1) The certainty with which the long-term economic   characteristics of the business can be evaluated;

     2) The certainty with which management can be evaluated,  both as to its ability to realize the full potential of  the business and to wisely employ its cash flows;

     3) The certainty with which management can be counted on to channel the rewards from the business to the shareholders rather than to itself;

     4) The purchase price of the business;

     5) The levels of taxation and inflation that will be experienced and that will determine the degree by which an investor’s purchasing-power return is reduced from his gross return.” http://www.berkshirehathaway.com/letters/1993.html

Each of these points made by Buffett on valuation deserves its own blog post, so I will leave it at that for now.  But the important point is (1) to have the discipline to do the work; (2) realize that mistakes will inevitably be made; and (3) build in a Margin of Safety.  In doing this analysis people like Buffett are very conservative:

 “We think about worst cases all the time and we add on a big margin of safety. We don’t want to go back to ‘Go.'”  http://articles.chicagotribune.com/2012-05-05/news/sns-rt-berkshiremeeting-highlights2l1e8g52t9-20120505_1_vice-chairman-charlie-munger-berkshire-meeting-berkshire-hathaway

 Warren Buffett has views on company valuation which echo Munger’s:

“Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.” http://alephblog.com/2011/10/20/value-versus-growth/

“Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor.”  http://www.buffettsecrets.com/company-growth.htm

In terms of valuing a company and its relation of Margin of Safety, I like a definition Michael Mauboussin once set out in an interview:

“Value, to me, is the present value of future cash flows, which would be relevant for any financial asset – present value of future cash flows. Value would be buying something for substantially less than what it’s worth, based on that stream of cash flows.  It’s as simple as that.  And the margin of safety, of course, reflects the distance…”   http://www.forbes.com/sites/steveforbes/2011/07/11/steve-forbes-interview-michael-mauboussin-professor-and-investor/

To which Mauboussin adds:

“A margin of safety- a concept attributable to Ben Graham- exists when an investor can purchase a stock well below its intrinsic value.  Buffett defines intrinsic value in no uncertain terms:  ‘it is the discounted value of the cash that can be taken out of a business during its remaining life.’”  http://people.stern.nyu.edu/adamodar/pdfiles/eqnotes/marginofsafety.pdf

Every so often someone will say that the ideas of people like Munger are old-fashioned.  One such case was during the 1999-2001 Internet stock bubble and that did not turn out well for people who doubted these principles.  Some promoters did well during that bubble, but that it another subject entirely.    Munger believes the Margin of Safety idea is timeless:

“The idea of a margin of safety, a Graham precept, will never be obsolete. The idea of making the market your servant will never be obsolete. The idea of being objective and dispassionate will never be obsolete. So, Graham had a lot of wonderful ideas.” (Wesco Annual  Meeting 2003) http://wealthymatters.com/2011/02/12/charlie-mungers-quotes-mungerisms/

Summing Up

As I did in the last chapter I will leave it to one person to summarize the ideas set out in this post.   James Montier:

“Valuation is the closest thing to the law of gravity that we have in finance. It is the primary determinant of long-term returns. However, the objective of investment (in general) is not to buy at fair value, but to purchase with a margin of safety. This reflects that any estimate of fair value is just that: an estimate, not a precise figure, so the margin of safety provides a much-needed cushion against errors and misfortunes. When investors violate [this principle] by investing with no margin of safety, they risk the prospect of the permanent impairment of capital.”  http://theguruinvestor.com/2011/05/20/the-seven-immutable-laws-of-investing/

Charlie Munger’s summary of all the four investing filters is to the point:

“The number one idea is to view a stock as an ownership of the business and to judge the staying quality of the business in terms of its competitive advantage. Look for more value in terms of discounted future cash-flow than you are paying for. Move only when you have an advantage.”  http://www.peregrineinvest.com/whatwedo.aspx?spid=109675&Title=Investing%20Words%20of%20Wisdom

It’s so simple! Most financial advisors try to make the investing process complex since otherwise they would have nothing to sell.  Of course, that the process is simple does not mean the process is not hard work or fun for some people .  The next post in this series will discuss whether people should be active or passive investors and whether diversification or concentration of investments makes sense in each case.

Categories: Uncategorized