Chapter 20. Margin of safety

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. This is the thread that runs through all the preceding discussion of investment policy—often explicitly, sometimes in a less direct fashion. Let us try now, briefly, to trace that idea in a connected argument.

MARGIN OF SAFETY로 요약가능하다.

All experienced investors recognize that the margin-of-safety concept is essential to the choice of sound bonds and preferred stocks. For example, a railroad should have earned its total fixed charges better than five times (before income tax), taking a period of years, for its bonds to qualify as investment-grade issues. This past ability to earn in excess of interest requirements constitutes the margin of safety that is counted on to protect the investor against loss or discomfiture in the event of some future decline in net income. (The margin above charges may be stated in other ways— for example, in the percentage by which revenues or profits may decline before the balance after interest disappears—but the underlying idea remains the same.)

모든 경험있는 투자자들은 주식이나 채권을 살때 안전마진개념이 중요하다는것을 알고있다. 예를들어, 철도는 총 고정비용을 5배이상 벌어야한다. net income(순이익)이 미래에 감소하는 것에 투자자를 보호하는 안전마진이다. 이것은 미래의 순이익 감소에 대비하여 투자자를 보호하는 안전마진이다.

The bond investor does not expect future average earnings to work out the same as in the past; if he were sure of that, the margin demanded might be small. Nor does he rely to any controlling extent on his judgment as to whether future earnings will be materially better or poorer than in the past, if he did that, he would have to measure his margin in terms of a carefully projected income account, instead of emphasizing the margin shown in the past record. Here the function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future. If the margin is a large one, then it is enough to assume that future earnings will not fall far below those of the past in order for an investor to feel sufficiently protected against the vicissitudes of time.

채권 투자자는 미래 평균수익률이 과거와 같다고 생각하지않는다; 그렇게 생각한다면 마진이 매우 작을것이다. 미래 수익이 과거보다 좋을지 나쁠지에 대한 판단에 크게 의존하지 않는다. 이것은 미래에 대한 정확한 추정이 필요없게 만드는 안전마진의 기능이다. 만약 안전마진이 크다면, 미래 수익이 과거보다 크게 떨어지지 않을것이라고 가정하는것만으로도 투자자가 시간의 변화에 충분히 보호받는다. 이것이 안전마진의 기능으로, 본질적으로 미래에 대한 정확한 추정이 필요없게 만드는것이다. 마진이 크다면 미래 수익이 과거보다 크게 떨어지지 않을것이라고 가정하는것만으로도 투자자가 시간의 변화에 충분히 보호받는다.

The margin of safety for bonds may be calculated, alternatively, by comparing the total value of the enterprise with the amount of debt. (A similar calculation may be made for a preferred-stock issue.) If the business owes $10 million and is fairly worth $30 million, there is room for a shrinkage of two-thirds in value—at least theoretically—before the bondholders will suffer loss. The amount of this extra value, or “cushion,” above the debt may be approximated by using the average market price of the junior stock issues over a period of years. Since average stock prices are generally related to average earning power, the margin of “enterprise value” over debt and the margin of earnings over charges will in most cases yield similar results.

채권에 대한 안전마진은 계산이 가능한데, 기업의 총 가치와 부채의 양을 비교함으로써 계산할수있다. (우선주주식에 대해서도 비슷한 계산이 가능하다.) 만약 비즈니스가 1억을 빚지고, 3억의 가치가 있다면, 채권자가 손실을 입기전에 가치의 2/3이 줄어들수있다. 이 추가 가치나 쿠션은 몇년간 주식시장의 평균가격을 사용하여 근사할수있다. 평균 주가는 일반적으로 평균 수익력과 관련이 있기때문에, 기업가치와 부채의 마진과 수익과 부담의 마진은 대부분의 경우 유사한 결과를 제공할것이다.

So much for the margin-of-safety concept as applied to “fixed-value investments.” Can it be carried over into the field of common stocks? Yes, but with some necessary modifications. There are instances where a common stock may be considered sound because it enjoys a margin of safety as large as that of a good bond. This will occur, for example, when a company has outstanding only common stock that under depression conditions is selling for less than the amount of bonds that could safely be issued against its property and earning power.* That was the position of a host of strongly financed industrial companies at the low price levels of 1932–33. In such instances the investor can obtain the margin of safety associated with a bond, plus all the chances of larger income and principal appreciation inherent in a common stock. (The only thing he lacks is the legal power to insist on dividend payments “or else”—but this is a small drawback as compared with his advantages.) Common stocks bought under such circumstances will supply an ideal, though infrequent, combination of safety and profit opportunity. As a quite recent example of this condition, let us mention once more National Presto Industries stock, which sold for a total enterprise value of $43 million in 1972. With its $16 millions of recent earnings before taxes the company could easily have supported this amount of bonds. In the ordinary common stock, bought for investment under normal conditions, the margin of safety lies in an expected earning power considerably above the going rate for bonds. In former editions we elucidated this point with the following figures:

Assume in a typical case that the earning power is 9% on the price and that the bond rate is 4%; then the stockbuyer will have an average annual margin of 5% accruing in his favor. Some of the excess is paid to him in the dividend rate; even though spent by him, it enters into his overall investment result. The undistributed balance is reinvested in the business for his account. In many cases such reinvested earnings fail to add commensurately to the earning power and value of his stock. (That is why the market has a stubborn habit of valuing earnings disbursed in dividends more generously than the portion retained in the business.)* But, if the picture is viewed as a whole, there is a reasonably close connection between the growth of corporate surpluses through reinvested earnings and the growth of corporate values.

Over a ten-year period the typical excess of stock earning power over bond interest may aggregate 50% of the price paid. This figure is sufficient to provide a very real margin of safety—which, under favorable conditions, will prevent or minimize a loss. If such a margin is present in each of a diversified list of twenty or more stocks, the probability of a favorable result under “fairly normal conditions” becomes very large. That is why the policy of investing in representative common stocks does not require high qualities of insight and foresight to work out successfully. If the purchases are made at the average level of the market over a span of years, the prices paid should carry with them assurance of an adequate margin of safety. The danger to investors lies in concentrating their purchases in the upper levels of the market, or in buying nonrepresentative common stocks that carry more than average risk of diminished earning power.

In the ordinary common stock, bought for investment under normal conditions, the margin of safety lies in an expected earning power considerably above the going rate for bonds. In former editions we elucidated this point with the following figures: Assume in a typical case that the earning power is 9% on the price and that the bond rate is 4%; then the stockbuyer will have an average annual margin of 5% accruing in his favor. Some of the excess is paid to him in the dividend rate; even though spent by him, it enters into his overall investment result. The undistributed balance is reinvested in the business for his account. In many cases such reinvested earnings fail to add commensurately to the earning power and value of his stock. (That is why the market has a stubborn habit of valuing earnings disbursed in dividends more generously than the portion retained in the business.)* But, if the picture is viewed as a whole, there is a reasonably close connection between the growth of corporate surpluses through reinvested earnings and the growth of corporate values.

채권수익률이 4%이고 주식이 9%라면 5%의 마진을 얻는다.

10년물 채권수익률의 2배이면 margin of safety. 위험은 시장이 비쌀때 사거나, 대표성이 없는 종목을 사는것이다.

As we see it, the whole problem of common-stock investment under 1972 conditions lies in the fact that “in a typical case” the earning power is now much less than 9% on the price paid.* Let us assume that by concentrating somewhat on the low-multiplier issues among the large companies a defensive investor may now acquire equities at 12 times recent earnings—i.e., with an earnings return of 8.33% on cost. He may obtain a dividend yield of about 4%, and he will have 4.33% of his cost reinvested in the business for his account. On this basis, the excess of stock earning power over bond interest over a ten-year basis would still be too small to constitute an adequate margin of safety. For that reason we feel that there are real risks now even in a diversified list of sound common stocks. The risks may be fully offset by the profit possibilities of the list; and indeed the investor may have no choice but to incur them—for otherwise he may run an even greater risk of holding only fixed claims payable in steadily depreciating dollars. Nonetheless the investor would do well to recognize, and to accept as philosophically as he can, that the old package of good profit possibilities combined with small ultimate risk is no longer available to him.*

1972에 문제는 일반주를 매수할때 수익력이 9%보다 훨씬 낮았다는것이다. 9%를 기대하는데, 12배 per주식을 산다면. 8.33%리턴을 기대하는것이다. 위험이 있다. 3.5% 7%를 기대해야하는데, 삼성전자per은 5%이다. margin of safety가 아니다. 달러만 들고있다면 그것도 위험하다 인플레이션때문에.. Good profit과 small risk는 없다. (PER로 1년 수익률을 계산하고, 그것을 현재 금리와 비교한다)

However, the risk of paying too high a price for good-quality stocks—while a real one—is not the chief hazard confronting the average buyer of securities. Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions. The purchasers view the current good earnings as equivalent to “earning power” and assume that prosperity is synonymous with safety. It is in those years that bonds and preferred stocks of inferior grade can be sold to the public at a price around par, because they carry a little higher income return or a deceptively attractive conversion privilege. It is then, also, that common stocks of obscure companies can be floated at prices far above the tangible investment, on the strength of two or three years of excellent growth.

좋은 주식을 비싸게 사는건 큰 문제가 아니다. 회사가 잘나갈때 품질이 낮은 주식을 사는데서 위험은 발생한다. 대중에게 그런 안좋은 주식이 팔릴수있다. 왜냐면 그들은 약간 높은 수익률이나 attractive할수있다. 그래서 잘 모르는(obsecure)회사들이 매우 비싸게 팔릴수있고, 2~3년간 매우 높은 성장률에 의해서. 구매자 시각에서 현재의 좋은 수익은 earning power로 보이고 safe하다고 느낄수있다. (2~3년만 보고 판단하지말자)

These securities do not offer an adequate margin of safety in any admissible sense of the term. Coverage of interest charges and preferred dividends must be tested over a number of years, including preferably a period of subnormal business such as in 1970–71. The same is ordinarily true of common-stock earnings if they are to qualify as indicators of earning power. Thus it follows that most of the fair-weather investments, acquired at fair-weather prices, are destined to suffer disturbing price declines when the horizon clouds over—and often sooner than that. Nor can the investor count with confidence on an eventual recovery—although this does come about in some proportion of the cases—for he has never had a real safety margin to tide him through adversity.

이러한 주식은 안전마진을 제공하지않는다. 이자와 우선주배당을 몇년간 테스트해봐야한다. 일반적으로 주식수익도 earning power를 나타내기위해 테스트해봐야한다. 그래서 fair-weather price로 산 fair-weather investment는 구름이 끼면 가격이 떨어진다. 그리고 그것이 회복될것이라고 확신할수없다. 왜냐면 진짜 안전마진이 없기때문이다.

The philosophy of investment in growth stocks parallels in part and in part contravenes the margin-of-safety principle. The growth-stock buyer relies on an expected earning power that is greater than the average shown in the past. Thus he may be said to substitute these expected earnings for the past record in calculating his margin of safety. In investment theory there is no reason why carefully estimated future earnings should be a less reliable guide than the bare record of the past; in fact, security analysis is coming more and more to prefer a competently executed evaluation of the future. Thus the growth-stock approach may supply as dependable a margin of safety as is found in the ordinary investment—provided the calculation of the future is conservatively made, and provided it shows a satisfactory margin in relation to the price paid.

성장주 투자자는 과거성장률에 의존한다. 그것을 안전마진이라 볼수있다. 미래에 대한 계산이 보수적으로 이뤄지고 만족스러운 마진이라면 dependable a margin of safety라 할수있다.

The danger in a growth-stock program lies precisely here. For such favored issues the market has a tendency to set prices that will not be adequately protected by a conservative projection of future earnings. (It is a basic rule of prudent investment that all estimates, when they differ from past performance, must err at least slightly on the side of understatement.) The margin of safety is always dependent on the price paid. It will be large at one price, small at some higher price, nonexistent at some still higher price. If, as we suggest, the average market level of most growth stocks is too high to provide an adequate margin of safety for the buyer, then a simple technique of diversified buying in this field may not work out satisfactorily. A special degree of foresight and judgment will be needed, in order that wise individual selections may overcome the hazards inherent in the customary market level of such issues as a whole.

성장주 투자의 위험성은 여기에 있다. 호감을 받는 주식에 대해 시장은 미래 수익에 대해 보수적으로 판단하지않는다. (과거 성과와 다르다면 understatement에 대한것은 에러를 내야하는건 기본적인 규칙이다.) 안전마진은 가격에 의존한다. 가격이 낮으면 안전마진이 크고, 높으면 작고, 더 높으면 없다. 만약, 시장이 대부분의 성장주가 적절한 안전마진을 제공하지않는다면, 분산투자하더라도 만족스러운 결과를 주진않을것이다. 이 분야에서의 일반적인 시장수준에 내재된 위험을 극복하기위해 특별한 선견지명과 판단력이 필요할것이다. 다(시장은 특정 호감주식에 대해 낮은 earning에도 관대해지고 어느 시점에서는 분산투자로도 안전마진을 얻기 힘들다, → 이땐 워렌버핏을 보자)

The margin-of-safety idea becomes much more evident when we apply it to the field of undervalued or bargain securities. We have here, by definition, a favorable difference between price on the one hand and indicated or appraised value on the other. That difference is the safety margin. It is available for absorbing the effect of miscalculations or worse than average luck. The buyer of bargain issues places particular emphasis on the ability of the investment to withstand adverse developments. For in most such cases he has no real enthusiasm about the company’s prospects. True, if the prospects are definitely bad the investor will prefer to avoid the security no matter how low the price.But the field of undervalued issues is drawn from the many concerns—perhaps a majority of the total—for which the future appears neither distinctly promising nor distinctly unpromising. If these are bought on a bargain basis, even a moderate decline in the earning power need not prevent the investment from showing satisfactory results. The margin of safety will then have served its proper purpose.

정의에 따라, price와 value의 차이가 안전마진이다. bargain issue를 사는 사람은 불확실한 미래에 대비할수있는 능력에 중점을 둔다. 미래가 확실하게 나쁘다면, 가격이 얼마나 낮던 피하고싶어할것이다. 하지만 undervalued issue는 미래가 확실하게 좋지도 않고 나쁘지도 않다. (알수없다.) 이것들이 bargain basis로 사면, moderate decline이라도 만족스러운 결과를 보여줄수있다. (즉, 싸게 사면, 좀 하락하더라도 괜찮다.)

Theory of Diversification

There is a close logical connection between the concept of a safety margin and the principle of diversification. One is correlative with the other. Even with a margin in the investor’s favor, an individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss—not that loss is impossible. But as the number of such commitments is increased the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses. That is the simple basis of the insurance-underwriting business. Diversification is an established tenet of conservative investment. By accepting it so universally, investors are really demonstrating their acceptance of the margin-of-safety principle, to which diversification is the companion. This point may be made more colorful by a reference to the arithmetic of roulette. If a man bets $1 on a single number, he is paid $35 profit when he wins—but the chances are 37 to 1 that he will lose. He has a “negative margin of safety.” In his case diversification is foolish. The more numbers he bets on, the smaller his chance of ending with a profit. If he regularly bets $1 on every number (including 0 and 00), he is certain to lose $2 on each turn of the wheel. But suppose the winner received $39 profit instead of $35. Then he would have a small but important margin of safety. Therefore, the more numbers he wagers on, the better his chance of gain. And he could be certain of winning $2 on every spin by simply betting $1 each on all the numbers. (Incidentally, the two examples given actually describe the respective positions of the player and proprietor of a wheel with 0 and 00.)*

개별 주식은 확률은 같지만 손실이 없다는것을 보장하지않는다. 분산투자를 통해 안전마진을 만들수있다.

A criterion of investment vs speculation

Investment and speculation, there’s no single definition. To have a true investment, there must be present a ture margin of safety. Speculers rest on subjective judgement. Margin of safety is well supported by practical investment experience. A true margin of safety is one that can be demonstrated by fitures, by persuasive reason, and by reference to a body of actual experience.

[BOOK REVIEW] Intelligent investor chapter 20. Margin of safety

Chapter 20. Margin of safety

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