Benjamin Graham and the Margin of Safety

Benjamin Graham reduced sound investing to three words: margin of safety. Buy an asset for much less than it is worth, and the gap protects you from error, bad luck and the unknown. Almost every value investor since, including his student Warren Buffett, has built on that idea.

A lesson paid for in 1929

Graham was a successful Wall Street manager in the 1920s. Between 1929 and 1932 his fund lost roughly 70%. The experience shaped everything he wrote afterwards.

In 1934 he and David Dodd published Security Analysis, the first rigorous textbook on valuing securities. In 1949 came The Intelligent Investor, written for the general reader. Buffett has called it the best book on investing ever written.

Investment versus speculation

Graham drew a sharp line. An investment, after thorough analysis, promises safety of principal and an adequate return. Anything else is speculation.

The distinction is about method, not the asset. A share can be an investment at one price and a speculation at another.

The margin of safety

Engineers build a bridge to carry far more than its expected load. Graham applied the same thinking to stocks. If a business is worth 100 and you pay 60, you can be substantially wrong and still not lose.

The margin does three jobs:

• It absorbs mistakes in your own analysis.
• It cushions against events nobody could forecast.
• It supplies the return when the price moves back towards value.

The less certain the valuation, the wider the margin must be.

Mr. Market

Graham asked readers to imagine a business partner called Mr. Market. Every day he offers to buy your share or sell you his. Some days he is euphoric and names a high price. Other days he is miserable and names a low one.

You are free to ignore him. His quotes are there to serve you, not to guide you. An investor who lets Mr. Market's mood set his own opinion has turned an advantage into a liability.

Net-nets

Graham's strictest method was to buy companies trading below their net current assets: cash, receivables and inventory minus all liabilities. In effect, the buyer got the factories and the business for nothing. Such bargains were common after the Depression and are rare now.

His one great departure from his own rules was GEICO, a growth company that made his partnership more than all its other investments combined.

Defensive and enterprising investors

Graham did not think everyone should pick stocks. The defensive investor should hold a diversified mix of quality shares and bonds and rebalance. Only the enterprising investor, willing to treat it as a serious job, should attempt more.

What to take from it

• Never buy without a gap between price and your estimate of value.
• Widen the gap when you are less sure.
• Use market swings; do not take instruction from them.
• Be honest about whether you are a defensive or enterprising investor.

Part 10 of 15 in the series Lessons From the Masters. Next: John Templeton: Buying When Everyone Else Is Terrified.

Independent educational commentary, not investment advice. References to people and firms do not imply affiliation or endorsement. The picture is an illustration, not a photograph. Past results say nothing about future ones. Trading leveraged products carries a high risk of loss.