In The Intelligent Investor, published in 1949, Benjamin Graham wrote:
In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, “This too will pass.” Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.
…the function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future.
The last sentence points to the processes and qualities that separate value investors from most brokers and professional fund managers. Investing is a probabilistic endeavor and investors can do many things to put the odds of success in their favor, but having a “better” model to predict the future is not one of them. We can estimate probable outcomes and seek inexpensive protection for negative events, but we cannot know the future. Any investment philosophy that requires prognostication is doomed to underperform because most guesses are just as likely to be wrong as correct.
Unfortunately for many brokerage customers, most investment recommendations are based on prognostication, whether it is a guess about next quarter’s earnings or a likely takeover target. And, most professional fund managers buy everything in their benchmark indexes anyway, whether or not the companies in that index are overvalued.
It is worth repeating: A margin of safety in investing reduces the need for an accurate prediction of the future. The investment process focuses instead on understanding the things that make a business valuable and whether the price in the marketplace for that business is significantly lower than its value.
Graham defined a margin of safety as “a favorable difference between price on the one hand and indicated or appraised value on the other.” Graham describes what he means by “indicated or appraised” value in the first chapter of Security Analysis, co-authored with David L. Dodd; it is “intrinsic value.”
About This Blog
This is a blog about investing. Graham made a distinction between investing and speculating:
An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.
This blog was created by Ray Galkowski when he was the portfolio manager of a private investment partnership. Ray had adopted the investment philosophy of Graham and Graham’s philosophical descendants (see “The Superinvestors” tab). Today that philosophy is known as value investing.
At various times over the past 75 years, investment fads have led many professional investors and pundits to say that Graham’s approach to investing was no longer applicable. This sentiment was perhaps never more fervently or widely held as during the tech bubble of the 1990s. But, many current value investors such as Seth Klarman have proven that Graham’s approach to investing is simply sound investing, and that everything else is speculation; they have proven that by delivering consistent, long-term, market-beating returns.
Klarman is a founder of The Baupost Group, a multi-billion dollar value-focused hedge fund. He wrote a book called Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor. And, he wrote the Preface to the Sixth Edition of Benjamin Graham and David L. Dodd’s Security Analysis. Klarman’s preface was titled The Timeless Wisdom of Graham and Dodd.
Graham’s philosophy is likely to remain timeless because of institutional investor constraints and human behavioral flaws. We plan to have much to say about each of these phenomena on this blog.
Also, since the early 1960s, many professionals and pundits have declared that markets are too efficient to beat, that any outperformance is due to luck, and therefore it is better to buy a little bit of everything in an index. We think Warren Buffett addressed this issue best in The Superinvestors of Graham-and-Doddsville (See The Superinvestors Tab).
There are many outstanding value-investing resources. Our goal for this blog is to add value by:
- aggregating the resources that we deem important in developing a sound value-investing process;
- pointing to current books, letters, articles, and media files from some of the world’s leading investors and academics that offer investing insight; and
- including some original research of our own;
We will make every reasonable effort to disclose potential conflicts when we write about a particular investment. As always, any posts about specific investments are not recommendations to buy or sell. Besides, Graham has cautioned that investing based solely on someone else’s recommendation–without doing your own research–is antithetical to a sound value-investing process and it leads to herding behavior.
About the Header Painting
Ulysses and the Sirens was painted by John William Waterhouse in 1891. The story of the Sirens’ Song is often used to demonstrate that humans tend to chase ephemeral and spurious answers, to their detriment.
In order for value investors to reap the full benefits of their investment philosophy they must invest only when they possess a margin of safety, which means buying assets at a significant discount to their true value. They must maintain discipline and possess a long-term view. Investment success requires a discipline and patience that few possess; discipline and patience to avoid jumping into investments solely because the market is rising, and discipline and patience to buy and hold quality investments when it seems that all others are fleeing.
Michael Mauboussin, Chief Investment Officer at Legg Mason, wrote in More than You Know: Finding Financial Wisdom in Unconventional Places:
Like Ulysses, money managers should take the steps necessary to focus on the long term if they are to optimize long-term fund performance.