Source: http://musingzebra.com/thoughts-on-dual-prime-redundancy-margin-of-safety/
It is a fact of life that things don’t always go according to plan. A missed train; a late delivery; a canceled order, but that’s okay. There’s always the next train. They are non-critical events. However, there are also many things that the cost of not working as planned are exceedingly costly. Think power plant system, mountain climbing, skydiving, aeronautics design, computer hardware & software system and so on. This is when it is critical to run through as many ‘what if’ scenarios as possible and come up with plan B, C or D to reduce the risk of failure or minimize losses.
Most engineering process, as I have named a few above, have redundancy built into their systems. Redundancy is simply a duplication of critical components to making sure if one fails, another one will kick in to ensure the system continues to run. For example, in skydiving, if the primary parachute malfunction, there’s a reserve one. The power plant has an emergency backup system and so does your home. You have spare tires in the car boot. Matt Bissonette described how Navy Seal has their own redundancy system in No Easy Day.
One is none. Two is one. Always carry two pens in case one doesn’t work. A simple math. If the chance of a pen is not working is 5% or 1 out of 20, the chance of two pens not working is 0.0025% (0.05 x 0.05) or 1 out of 400. Now you might say airplane can’t have extra wings. If they break, everyone dies. That is true and in this case, redundancy lies in the aircraft manufacturing and maintenance process that ensures they don’t break under extreme conditions.
The same concept applies to investing and it is more commonly known to us as the margin of safety. Having a margin of safety gives you an extra buffer against an investment situation where you will experience minimal to no losses in the case of bad outcomes.
We normally refer margin of safety as the difference between the share price and actual value of a stock. If the stock is worth $10, buying it at $5 gives you a margin of safety of 50%. Using another analogy, if a person looks 40s, it is a pretty safe bet if someone thinks that he looks 20s. But the concept of margin of safety carries more weights than just the gap between the price and value.
What else creates a margin of safety? Think for 2 minutes.
The list is not exhaustive but it should give you an idea how to view margin of safety in a broader sense.
Quality
A company that possesses strong quality in term of strong competitive advantage and economic durability has a higher margin of safety than a company with poor economics, even at a higher P/E. These qualities ensure there’s a high probability that the value of the stock will continue to increase over the long term. This is not to say it is completely risk-free but it is more favorable compare to companies that swim against the tide.
Investment process
A rigorous investment process has more margin of safety than decisions based on intuition or shortcuts. Anyone can apply a P/E or run a DCF model and come up with a figure that implies a margin of safety in the current price but that’s not a good process. Creating a robust investment process using tools like the checklist, multiple mental models and looking for contradictory information provides a better protection against any unexpected outcomes. I have written an extensive post on this.
Management
A prudent management that aligned their interest with the shareholders, run by a well and able people who possess strong integrity is going to give you a lot more good sleep than one run by people with an incentive towards fattening their own pocket. You might have a few investments in the latter that turn out really well, but it is a time bomb waiting to explode in your face.
Leverage
Debt-free companies have more room to maneuver compare to highly levered ones. This is especially critical during an economic downturn. The same applies to operating leverage. Companies with massive fixed costs, generally those with large fixed assets, well tend to do really well during a bull run as profit will rise faster than revenue but during a downturn, profit will get equally hammered.
Industry economics
An industry with stable fundamentals such as consumer products or healthcare is better than one operating in a cyclical climate such as automotive or minerals mining. Before making any investing, it is a good to have a thorough understanding of the industry dynamic.
You
This is the most important one. I have written a post here about the risk you might be unaware of. Things from your investment horizon, temperament, psychological makeup, the way you think are all going to determine the type of risk that you create or the lack of margin of safety, and it is important you are aware of them and knowing when they can fail you.
In a broad view, the margin of safety is a concept that starts from the beginning to the end. You don’t do it at the end after you’ve done valuation, but everything else before that as well. When you take all these into account, you are building a high degree of redundancy into your investment process. It is like having 5, 7, 8 pens.
It is a fact of life that things don’t always go according to plan. A missed train; a late delivery; a canceled order, but that’s okay. There’s always the next train. They are non-critical events. However, there are also many things that the cost of not working as planned are exceedingly costly. Think power plant system, mountain climbing, skydiving, aeronautics design, computer hardware & software system and so on. This is when it is critical to run through as many ‘what if’ scenarios as possible and come up with plan B, C or D to reduce the risk of failure or minimize losses.
Most engineering process, as I have named a few above, have redundancy built into their systems. Redundancy is simply a duplication of critical components to making sure if one fails, another one will kick in to ensure the system continues to run. For example, in skydiving, if the primary parachute malfunction, there’s a reserve one. The power plant has an emergency backup system and so does your home. You have spare tires in the car boot. Matt Bissonette described how Navy Seal has their own redundancy system in No Easy Day.
“Everybody was trained to dual prime explosives, which meant attaching two detonators to the charge in case one fails. The rule of thumb was simple: One is none. Two is one.”
One is none. Two is one. Always carry two pens in case one doesn’t work. A simple math. If the chance of a pen is not working is 5% or 1 out of 20, the chance of two pens not working is 0.0025% (0.05 x 0.05) or 1 out of 400. Now you might say airplane can’t have extra wings. If they break, everyone dies. That is true and in this case, redundancy lies in the aircraft manufacturing and maintenance process that ensures they don’t break under extreme conditions.
The same concept applies to investing and it is more commonly known to us as the margin of safety. Having a margin of safety gives you an extra buffer against an investment situation where you will experience minimal to no losses in the case of bad outcomes.
“When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And that same principle works in investing.” – Warren Buffett
We normally refer margin of safety as the difference between the share price and actual value of a stock. If the stock is worth $10, buying it at $5 gives you a margin of safety of 50%. Using another analogy, if a person looks 40s, it is a pretty safe bet if someone thinks that he looks 20s. But the concept of margin of safety carries more weights than just the gap between the price and value.
What else creates a margin of safety? Think for 2 minutes.
The list is not exhaustive but it should give you an idea how to view margin of safety in a broader sense.
Quality
A company that possesses strong quality in term of strong competitive advantage and economic durability has a higher margin of safety than a company with poor economics, even at a higher P/E. These qualities ensure there’s a high probability that the value of the stock will continue to increase over the long term. This is not to say it is completely risk-free but it is more favorable compare to companies that swim against the tide.
Investment process
A rigorous investment process has more margin of safety than decisions based on intuition or shortcuts. Anyone can apply a P/E or run a DCF model and come up with a figure that implies a margin of safety in the current price but that’s not a good process. Creating a robust investment process using tools like the checklist, multiple mental models and looking for contradictory information provides a better protection against any unexpected outcomes. I have written an extensive post on this.
Management
A prudent management that aligned their interest with the shareholders, run by a well and able people who possess strong integrity is going to give you a lot more good sleep than one run by people with an incentive towards fattening their own pocket. You might have a few investments in the latter that turn out really well, but it is a time bomb waiting to explode in your face.
Leverage
Debt-free companies have more room to maneuver compare to highly levered ones. This is especially critical during an economic downturn. The same applies to operating leverage. Companies with massive fixed costs, generally those with large fixed assets, well tend to do really well during a bull run as profit will rise faster than revenue but during a downturn, profit will get equally hammered.
Industry economics
An industry with stable fundamentals such as consumer products or healthcare is better than one operating in a cyclical climate such as automotive or minerals mining. Before making any investing, it is a good to have a thorough understanding of the industry dynamic.
You
This is the most important one. I have written a post here about the risk you might be unaware of. Things from your investment horizon, temperament, psychological makeup, the way you think are all going to determine the type of risk that you create or the lack of margin of safety, and it is important you are aware of them and knowing when they can fail you.
In a broad view, the margin of safety is a concept that starts from the beginning to the end. You don’t do it at the end after you’ve done valuation, but everything else before that as well. When you take all these into account, you are building a high degree of redundancy into your investment process. It is like having 5, 7, 8 pens.
