Margin of safety, objective ignorance, uncertainty
My primary goal at this time is avoiding any “unforced errors.” At the end of last year, I wrote:
I think the biggest challenge of 2022 will be to resist lowering my standards by investing in average but not great situations, with inadequate margins of safety, because of FOMO.
After the recent downturn, I opened a few new positions that probably qualified as “average but not great" situations. Although they worked out fine short term, this was probably due more to luck than skill. These situations were merely attractive on a relative basis - some good companies were significantly cheaper than they had been. But on an absolute, intrinsic value basis, these companies were still expensive.
My definition of intrinsic value is simple and unoriginal: it is the present value of predicted future cash flows for the business. There is admittedly a lot of uncertainty in this definition (present value depends on your discount rate and any prediction of the future is likely to be riddled with errors), but this uncertainty can be partly mitigated by having adequate diversification and a large “margin of safety” in the purchase price.
For example, maybe you think a company is worth $10, but there is a wide range of uncertainty around your estimate, so you force yourself to wait until it drops to $7. It seems odd that the “true value” of a company should fluctuate so much in an “efficient market,” but in my experience you can almost always buy a company at the right price if you are patient enough.
This process can be frustrating in that you may miss out on some opportunities. Perhaps the stock price drops to $7.50, but your arbitrary purchase threshold is $7. You never buy in, and the stock subsequently goes up to $15. You miss out on gains because you were too conservative.
On the other hand, if you buy in at $10, and the stock goes down to $7, you’ve lost 30%. Perhaps your initial estimate of fair value was wrong, and it turns out the company is worth far less than you thought. In this case, you may suffer a permanent loss of capital.
By consistently demanding a margin of safety in your purchase price, you might forgo the opportunities for some gains, but should also avoid the potential for large losses. This approach seems straightforward, but it is hard to execute when emotionally bombarded with hyperbolic daily news and large, volatile market swings. It is also easy relax your standards by selling yourself narratives grounded in hope:
“This is a great company, so I should be willing to relax my standards a bit”
“The stock price has fallen 80%, so the company must be cheap now”
“The company is unprofitable now, but it will be profitable in the future”
“There is no other alternative”
“This time is different”
Another way of looking at margin of safety is that it protects you against the downside from your own “objective ignorance” - basically, the idea that there are things about the future that are simply unknowable (i.e. war, pandemics, inflation). If you believe that any prediction about a business’s prospects contains some irreducible, unknowable uncertainty, then a margin of safety gives you a buffer against potential downside that you fail to anticipate.
The danger is that you are overly conservative for too long a time, and that you miss out on the historical tendency for the market to rise over long periods of time. Still, this risk might be overstated: the S&P 500 has lagged the return on treasury bills from 1929-1947, 1966-1985, and 2000-2013, 50 out of 84 years.
This post is just a reminder to myself that the strategy is pretty simple:
Calculate the intrinsic value of a company
Wait until there is an attractive margin of safety before purchasing shares
Don’t commit any unforced errors by having a bias for action, fear of missing out, or instinct to follow the crowd
Simple, not easy.