Most investors are familiar with the margin of safety. Coined by Ben Graham and popularized by his disciples, margin of safety is the idea that you should buy a stock for less than your estimate of its intrinsic value. The bigger the difference between price and your estimate of intrinsic value, the more leeway you have to account for the possibility that your estimate is wrong. Margin of safety is what Buffett is referring to when he says value investing is about buying a dollar for fifty cents.
Unfortunately for today’s investors, Graham and young Buffett et al operated in a bygone era. An analyst who trekked out to the local library to do research could gain a perceptible information advantage over the market. But with improvements in accounting and fair disclosure rules, the proliferation of the internet and mobile computing, hundreds of thousands of investment analysts across the world can now access all publicly available information on a company at the tap of a screen, without even rolling out of bed.
While active investors by definition must reject the strong-form Efficient Market Hypothesis (“EMH”), even the most ardent opponents of EMH would be foolish not to contemplate that with the gradual demise of information asymmetry, the market is more efficient today than it was back in Graham’s day. This is not to say that pockets of inefficiency can no longer exist, as Mr Market remains just as manic-depressive as he was one hundred years ago. However, it does mean that investors must confront an inconvenient, and perhaps uncomfortable, truth: the margin of danger.
The margin of danger is not the ugly sibling of the margin of safety; they are one and the same, which makes the idea all the more confronting for value investors. A stock perceived to be trading at half of its intrinsic value has a 50 per cent margin of safety, but conversely also a 50 per cent (or more) margin of danger—that is, the magnitude by which the estimate of intrinsic value could be wrong. Additionally, the bigger the difference between consensus market price and intrinsic value, the higher the probability that the analysis of intrinsic value is wrong.
In a world where thousands of smart, well-educated and well-resourced analysts and investors are scouring the same universe of stocks looking for bargains, finding an undervalued stock should not immediately be a Eureka! moment. Instead, the first thing investors should do is ask “have I made a mistake in my estimation of intrinsic value?” Mistakes can be as simple as linking to the wrong cell or entering the wrong formula in a spreadsheet, to misunderstanding the business model, failing to properly discount known unknowns, or failing to appreciate that there could be unknown unknowns.
Humans are proud by nature and don’t like to admit mistakes, let alone proactively prod for potential mistakes in their best ideas (a process known as “pre-mortem”). A common mindset for evading the inconvenient margin of danger—particularly for professional investors—is a misguided belief that simply because they diligently run a rigorous research process every day and “get into the details”, they will emerge with superior variant perceptions (i.e. different and right) that allow them to snap up undervalued stocks at bargain prices. Unfortunately, thousands of other investment analysts are in the market thinking and doing the same. It would be naïve to firmly hold onto the belief that one has a superior process that always produces superior insights that are both different and right vs the market consensus.
A second mindset that leads many investors to buying into perceived margins of safety, while rejecting any notion of the margin of danger (recall that they are the same thing), is a too-liberal interpretation of the moral of that well-worn Chicago joke about a student spotting a $20 note on the ground and her economics professor dismissing it as nonsense, because if the note was real, someone would have picked it up already. The joke ridicules strict adherents of strong-form EMH for not investing in apparently undervalued stocks, because if the stock was truly undervalued, someone else would have bid the price up to fair value. Therefore, the interpretation goes, an investor who finds a stock with a large margin of safety should go ahead and buy it.
But this is a poor analogy for real investing, because the action of picking up the $20 note is free and perfectly riskless. In reality, buying an undervalued stock is not free. There are transaction and opportunity costs, the potential return is not guaranteed as the intrinsic value could be overestimated, and there is a probability of loss as the analysis could be completely wrong or an unknown unknown transpires that completely changes the equation. Sometimes the professor is right, and the $20 note is not real.
Stay tuned for Part II next week which will go through how Montaka deals with the margin of danger.