Buffett believes that long-term-focused investing within your circle of competence will result in wealth for smart investors. This view is complemented by his risk-averse nature. All investing involves risk, naturally. There are unknowns inherent in making the choice to trade your money for a piece of a company—the future is never certain, after all. But Buffett believes that to be as successful as possible, you should do everything you can to limit your risk, and therefore lessen the likelihood that you’ll lose all-important capital (or money you can invest). He believes in tilting the scales as far as possible away from speculation and toward an ownership-minded investing framework.
We’ve already learned about moats and competitive advantages, so now’s the time to embrace the concept that Buffett has called “the cornerstone of investment success.”1 That important concept is called “margin of safety.”
Like much of his investing philosophy, Buffett learned about the idea of margin of safety from Ben Graham. This principle was key to Graham’s value investing school of thought, and the concept even gets its very own chapter in The Intelligent Investor. Without getting too much into financial nitty-gritty here, a margin of safety represents the leeway investors give themselves when purchasing shares of a company. Graham believed that because investors can’t with precise certainty know how much a company is actually worth (a best estimate is still just that—an estimate), you should reduce your risk of both being wrong and of being subjected to the market’s vagaries by giving yourself an appropriate margin of safety.
For example, let’s say you believe ABC company is worth $100 a share, and it’s currently trading at $75 a pop. Buying shares at that price would give you a margin of safety of 25 percent (some value investors insist on at least a 40–50 percent margin of safety). Instituting a margin of safety for your stock purchases is a way of managing the risk involved with investing, and the wider the margin, the more protection you give yourself. You can even adjust your required margin of safety to be higher with certain industries, such as more volatile or unpredictable ones, and lower with bigger, more established and reliable companies. The goal is to limit your losses, not eliminate the possibility of them altogether—that would be ideal, of course, yet impossible.
For Buffett, the concept of margin of safety is integral to the act of investing as a way to manage risk. He’s often quoted as saying, “Rule No. 1: Never lose money. Rule No. 2: Never forget Rule No. 1.”2 It’s unfortunately a certainty that every investor is going to lose some money at some point, but Buffett’s point here is to focus on doing what you can to avoid losing more than you have to. Sounds easy, yes, but the truth is that making hasty decisions and paying more for a company than you should can saddle your portfolio with losses that can take years to undo, as well as shrink your precious capital. Preserving the capital you have to invest is of paramount importance, and you should do everything you can to guard against the loss of this capital. Buying with a margin of safety in place helps lessen this possibility.
Back in the 1970s, as we mentioned before, Berkshire started buying shares of the Washington Post Company. After analyzing it, Buffett believed its assets were worth at least $400 million, yet the market was giving it a price tag of less than $100 million.3 This represented a margin of safety of 75 percent—a steal! Berkshire bought shares and held on, though Buffett wasn’t initially rewarded for his prescience. As we also discussed earlier, right after Buffett invested in the Post, shares dropped and remained below what Buffett thought they were worth for three years.
This illustrates another important point about margin of safety—Buffett had done his homework and was certain the market was mispricing the Post, woefully so, in fact. He could be comfortable being patient and holding on to his shares. He was confident enough in his analysis that he believed he would eventually be proven correct, and he’d bought himself enough wiggle room (more than enough, in fact) to wait for the market to reward him. However, had he bought with no margin of safety, overpaying for his shares of the Post, he’d be much less certain that any eventual return he might earn on the shares would be thanks to anything more than blind luck—or other suckers willing to pay more than he did. And that would make waiting much more nerve-racking.
Calculating a company’s intrinsic value, which you need to do before you can start thinking about whether there’s an acceptable margin of safety, is a complex task, and one that we won’t tackle here. However, there are ample resources available on www.fool.com should you want to investigate further and learn how to put this into action. The main point for now is to understand what it represents and how Buffett employs the concept of margin of safety to limit his risk. Advanced investors and value hounds do the same. Perhaps you’re now intrigued enough to join them.
Another way that Buffett shuns risk is found in his attitude toward debt. Given his cautious nature, it’s not surprising that he’s not a big proponent of debt, whether we’re talking about personal debt or debt that Berkshire or other companies have on their books, because of the risk too much debt can bring. The problem with debt is that its overuse can be disastrous when times get rocky. Buying stocks on margin (that is, using borrowed money from your broker), for example, can create trouble when stocks plummet, because your nervous broker is going to want its money back.
Think about credit card debt—the principle’s the same. When times are flush, you can use your credit card sensibly, you have no trouble keeping up with your payments, and you can use the credit as it was intended—as a tool but not a crutch. However, one lost job or big uncovered medical bill later, and it’s easy to get behind if you’ve overrelied on credit and run up an unwieldy amount buying faux-mink neck warmers, gold coffee tables, and a fleet of hot-air balloons. It can turn a bad situation into a much worse one (but at least you have your neck warmers to, you know, keep you warm).
The same goes for businesses that borrow money, whether to finance new ventures, build or improve buildings or plants, or pay temporary operating costs. A little debt, managed well, normally won’t create havoc. But beware piling it on. Dark times can mean missed payments, which for a company needing loans in the future can mean doubts about its creditworthiness. And those doubts register with investors, too, who may flee debt-laden companies for other more cash-rich outfits.
Buffett likes to keep Berkshire as cash rich as possible. In his 2008 letter to shareholders, he wrote, repeating thoughts he’d shared before, “However, I have pledged—to you, the rating agencies and myself—to always run Berkshire with more than ample cash. We never want to count on the kindness of strangers in order to meet tomorrow’s obligations. When forced to choose, I will not trade even a night’s sleep for the chance of extra profits.”4
It’s telling that a master investor such as Buffett refuses to allow Berkshire to take on significant amounts of debt. If he doesn’t trust it—and we are talking about the greatest investor of all time here, a mathematical mastermind like no other—then how should the rest of us be approaching the question of debt? It, without a doubt, raises your risk. The safest thing to do, when practicable, is to avoid it like Buffett does.
Buffett also limits his risk exposure by staying within his so-called “sphere of understanding,” as we discussed in an earlier chapter. By sticking to what he knows, Buffett lowers his risk of a poor decision based on faulty knowledge and assumptions. That’s not to say the man never makes mistakes (we’ll get to some of his most notable ones later on), but he does what he can to make as few as possible.
Buffett further manages his risk by investing mostly in companies based in America versus buying foreign stocks. Berkshire’s owned shares of various international companies over the years, including the Irish beer business Guinness, the Chinese oil company PetroChina, and a couple of Irish banks. Berkshire also owns the Israeli automated toolmaker Iscar outright, and has recently owned shares of BYD, a Chinese company that makes batteries, electric cars, and mobile phones. But for the most part, Buffett has stuck close to home.
There are great advantages to investing overseas—you can own shares of newer, faster-growing companies in new markets, for one thing. But there are risks, too. Knowing the geopolitical climate behind every market, as well as differing accounting rules, adds a layer of complexity to investment decisions. For Buffett, for the most part, that’s a risk he’s chosen to pass on.
All investing involves risk. The quicker you get used to and comfortable with this fact, the better. However, there’s no need to take on more risk than is necessary. Follow Buffett’s lead here:
• Insist on an appropriate margin of safety.
• Avoid debt as much as possible.
• Stay within your circle of competence.
• Do your homework before investing overseas.