Saturday, May 2, 2009

Margin Of Safety: Chapter 6

This chapter is dedicated to describing the philosophy of value investing and why it works. The terms used to describe value investing don't require any accounting or finance background, making this an easy read for beginners looking to learn about value investing.

Value investing is described as paying 50 cents for a business worth $1. Warren Buffett's analogy using the maximum allowable weight of a bridge is used to illustrate how this margin of safety works:

"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." 

What allows value investors to apply a margin of safety while most speculators and investors do not? Again Klarman uses a Buffett analogy to illustrate this:

A long-term-oriented value investor is a batter in a game where no balls or strikes are called, allowing dozens, even hundreds, of pitches to go by, including many at which other batters would swing. Value investors have infinite patience and are willing to wait until they are thrown a pitch they can handle—an undervalued investment opportunity.

As a result, Klarman asserts that value investors do not buy businesses they do not understand, nor ones that they find risky. For example, they will avoid technology companies and commercial banks. Value investors will also invest where their securities are backed by tangible assets, to protect them from downside risk.

Because the future is unknown (e.g. a business worth $1 today might be worth 75 cents or $1.25 tomorrow), there is little to be gained by paying $1 for this business. The margin of safety (buying at a discount) is therefore of utmost importance. Since institutions do not buy with a margin of safety, remain fully invested at all times, and trade stocks like pieces of paper with little regard to the underlying asset values, value investors gain an advantage.


Anonymous said...

Mr. Munger on the same theme: “Some of the worst business decisions I’ve ever seen are those with future projections and discounts back. It seems like the higher mathematics with more false precision should help you but it doesn’t. They teach that in business schools because, well, they’ve got to do something. ” - from 08 investor meeting

does that mean they don't use some sort of DCF to value companies? if so, how do they value?


Saj Karsan said...

Considering the assets of the company (not JUST earnings) is a good first step. To value the company's future cash flow, DCF can be useful, but I think Munger takes issue with some of the projections that are made regarding endless growth and high terminal values. I believe Buffett and Munger use a conservative DCF using reliable values.