Originally posted February 28, 2017.
Billionaire investor Warren Buffett, on the heels of releasing his annual report, said, Monday, that the stock market isn’t in a bubble and “measured against interest rates, stocks actually are on the cheap side compared to historic valuations.” In the same interview, he also warned “That doesn’t mean the stock market can’t go down 20% tomorrow.” A buying opportunity he’d welcome with open arms. It’s good to be Warren.
It’s funny how life works because, coincidentally, later that day I was speaking with clients who live in the Laguna Beach area. As we got to talking about how crazy the real estate market is, they said Warren Buffett is selling his house not far from theirs that he bought back in 1971. He’s asking $11 million. He paid $150,000. Isn’t time a wonderful luxury? Which brings me to margin of safety.
Margin of safety was the phrase made popular by Warren Buffett’s mentor and teacher at Columbia University, Benjamin Graham and is the central concept in Graham’s book The Intelligent Investor. It sits on my desk as a constant reminder of who I work for since it was a gift from Dick Young when I first began working with him back in 1998. It’s also worth noting I never remember hearing about the book in business school. Margin of safety must be too boring.
At the core of margin of safety you’ll find common sense and reality. Warren Buffett does a good job of making things make sense. Here’s how he describes margin of safety:
If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. So, the more vulnerable the business is, assuming you still want to invest in it, the larger margin of safety you’d need. If you’re driving a truck across a bridge that says it holds 10,000 pounds and you’ve got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay; but if it’s over the Grand Canyon, you may feel you want a little larger margin of safety…
Much of my day is spent helping investors like you understand their margin of safety. I have found it’s often much lower than they themselves believe it to be. And unfortunately too many investors learn the hard way—they only realize their margin of safety threshold when it’s too late.
My takeaway for you today, and you can be sure I’ll write more on this in future posts, is that Warren Buffett’s margin of safety is different than yours or mine, just like it was different from Ben Graham’s. There’s a difference between your truck and Warren Buffett’s. Don’t believe it for a second if you think he’s driving over the Grand Canyon with his life savings in it. But you know who’s buying yours if the bridge doesn’t hold.