Margin of Safety

Investing is subject to uncertainty. Not only are we dealing with estimation of future events with a variety of possible outcomes, but there is large room for doubt about some of the variables used in the calculation of intrinsic value. We could be wrong about many things, for example:

• Economic franchise evaluation: perhaps the strength or durability of the competitive advantage and the characteristics of the industry are not as good as we think they are.
• Management evaluation: judging people, especially if you don’t work with them day-in-day-out, can be extremely difficult.
• Financial strength: outsiders may not be in possession of the full facts.
• Discount rate: there is ample scope for different views on the most appropriate discount rate. Because there is so much potential for getting it wrong it is necessary to build-in a large margin of safety. It is only when the difference between intrinsic value and current stock price is screaming at you that you should buy.

Investing requires a detailed knowledge of each stock purchased. Such depth of understanding is impossible if there are more than a dozen companies in the portfolio. Indeed, most of us could only cope with three to seven stocks before losing track. Investors that can devote a great deal of time to stock selection may be able to follow the fortunes of eight to twelve companies. The rest of us have to make a judgment as to the appropriate number of stocks that we can deal with taking into account the time and energy we can spend on the exercise.

Remember risk is related to the amount of high quality intellectual effort put into the analysis of a security. This effort must be concentrated. Beyond the first four or five securities in a portfolio risk is not reduced much by further diversification on the principles of portfolio theory. But further diversification does increase the chance of failure to understand the businesses underlying the stocks, and therefore increases risk-- this increased risk factor quickly outweighs the benefits of greater diversification. Diversification is frequently undertaken because it is a protection against ignorance. Conventional stock pickers do not take the time to become knowledgeable about their companies and so, in their fear of the unknown, grasp for the safety of spreading the fund far and wide. This Noah’s Ark method of investing results in mediocre performance at best--you cannot watch all the eggs in all your baskets.

Investors must increase the intensity of analysis of particular businesses to reduce risk. They must not move too far down the diminishing marginal attractiveness curve. It is too difficult to be smart about investment choices day after day. Expect to make only a few key investment decisions in a lifetime (remember Buffett’s imaginary punch card with a maximum of 20 punches on
it) and to concentrate on being clever a few times.

Holding for the Very Long Term

Expect to hold stocks for a very long time. The investor almost never sells. This expectation helps to focus the mind when analyzing a stock for purchase--you will concentrate on the durability of the firm’s advantages rather than on short-term stock market movements. You will ask questions such as will the company still be the strongest in its sector in 30 years? Rather
than questions such as, is market sentiment moving away from telecoms and towards defensive stocks this month?

An ’almost never sell’ policy also means that you are not continually distracted by the illusory greenness of the grass on the other side of the fence. If the company has passed the tests of the long-term investor then it has many strengths, and you are unlikely to find alternative investments that possess all of these qualities. If you have held a stock for a long time you
become familiar with the company, its management and its industry. You are able to follow the evolving story and become increasingly knowledgeable.

Also, a policy of short-term stock holding can result in very burdensome transaction costs and taxes (more taxation in U.S. than in Singapore and Hong Kong). Plenty of other people become rich (e.g. brokers) while your wealth diminishes.

There are, however, times when it is necessary to sell a stock:
 

• When a mistake has been made in the original analysis--the factual background is significantly less favorable than believed at the time of purchase.
• The stock no longer qualifies under Valuegrowth investment rules. Through the passage of time, changes in the firm’s competitive qualities, the industry, the management or its finances, mean that the stock fails to have clearly visualized potential for high return. The story is no longer sound relative to the price.
• An even better opportunity arises. This is very rare and the investor should be very sure before dropping a well-understood company for a new one where the negatives may be hidden from view.

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