Margin Of Safety - The Most Important Thing

“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 natural vicissitudes of life.” – Charlie Munger

Perhaps the three most important words in investing are “Margin of Safety”. If you find something that you know is worth 100€, but you can get it for 90€, chances are you won’t be that excited. However, if this same thing is selling for 40€, you might be quite ecstatic.

Sometimes Mr. Market discounts heavily just to get rid of his merchandise. Be sure to pick up the best deals when he has an unannounced “Black Friday”.

We all love discounts. In clothing, food and appliances. We go out of our way to find the best deals on something we really want and this behavior is innate to us. For whatever reason, we don’t do this when buying stocks. Stocks are not just numbers that fluctuate, but real businesses that sell a real product or service and are worth something real. If you can figure out what something is worth, and pay a lot less for it, wouldn’t you be excited?

Bridges and Stocks

If you are building a bridge and it needs to be able to carry 10,000 tons, you make sure that the bridge can actually carry 15,000 tons, just in case. A margin of safety is built into the bridge, even though the sign says “10,000 tons max”.

It is known that in ancient Rome, the head engineer of a bridge was placed under it after construction. Then, the bridge was tested with heavy crossings. The head engineer probably knew his margin of safety well.

With stocks, If you buy them for a lot less than what they’re worth, you have a large margin of safety. Essentially what this means is that if things go wrong or don’t work out, you have not overpaid and can retrieve all or almost all of your initial investment. Mohnish Pabrai, one of my favorite investors has a great quote:

“The return of capital is more important than the return on capital”.

If you avoid disasters, the winners will take care of themselves.

Best Case Scenario

The absolute dream scenario is when a great business faces temporary (but solvable) problems. To give an example, the stock of Chipotle Mexican Grill [CMG] dropped in 2017. Apparently there was an isolated Norovirus case in Virginia, where some employees had laxed on their sick leave policies. CMG took a beating, but the intelligent investor could have spotted an opportunity and picked up a good, simple-to-understand business at a bargain price.

Dropping to a low of $289 in October 2017, 3 years later and now in the pandemic, going for a whopping $1258. An increase of 335% and CAGR of 63%.

The stock has picked up nicely since then (as the time of writing this in spring 2020).

** Update 29.10.2020: Another temporary drop came in March 2020, where you could have picked up some Mexican Grill for $465. Unfortunately now the p/e (150) looks insane. It’s priced as if it’s going to the moon. I do believe the company has a moat, but Mr. Market is absolutely not giving you a margin of safety.

One of the best books on investing ever written, by one of my favorite investors. Though its expensive on Ebay today, you can find PDF versions online.

I think Joel Greenblatt said it best: “If you do good valuation, I guarantee the market will agree with you. I just don’t know when”. When the market is pessimistic, it tends to unjustly punish stocks without consideration of the underlying business. When its optimistic, it easily leads to overvaluation. A case example would be Tesla. Here you can read my thoughts on the stock’s erratic behavior. Over time, business fundamentals and operations will reflect intrinsic value. In the short-run, stock prices can be all over the place. To conclude, I’ll leave you with a visualization on how the intelligent investor should behave.