Thursday, March 29, 2012

Benjamin Graham: Margin of Safety

From Chapter 20 of Ben Graham's book, The Intelligent Investor:

"...the risk of paying too high a price for good-quality stocks—while a real one—is not the chief hazard confronting the average buyer of securities. Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions. The purchasers view the current good earnings as equivalent to "earning power" and assume that prosperity is synonymous with safety."

Graham, later in the same chapter, added the following:

"...it follows that most of the fair-weather investments, acquired at fair-weather prices, are destined to suffer disturbing price declines when the horizon clouds over—and often sooner than that. Nor can the investor count with confidence on an eventual recovery—although this does come about in some proportion of the cases—for he has never had a real safety margin to tide him through adversity."

Highly cyclical, capital intensive businesses that have what seems like manageable debt can be far riskier than they seem when a healthy economy turns south.

They'll seem cheap in the good times but those with highly variable revenues, lots of fixed costs (operating leverage), and debt (financial leverage) are sometimes deceptively expensive.

What seems like normalized earnings in an expanding economy (and especially a bubble) turn out to be far from robust in a less favorable economic environment. Lower quality businesses end up struggling to cover interest charges and often can't lower their fixed operating expenses fast enough if the recession is severe enough.

Even if current owners don't get wiped out, a business that requires capital when it's scarce and common equity prices are low isn't the best thing to own.

One benefit of the recent financial crisis for investors is that it is easy to study which businesses had the toughest time during that period of severely reduced business activity.

It may not have been anything close to the worst economic conditions that could occur but was still a pretty good test.

The bottom line is that under favorable economic conditions some lower quality businesses have a margin of safety in appearance only.

The fact that a premium to intrinsic value was actually paid may not become obvious until it's too late.

Adam

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