The Dhandho Investor: Margin of Safety

Buying with a margin of safety is very important to author and fund manager Mohnish Pabrai (Trades, Portfolio), as it is to Warren Buffett (Trades, Portfolio) and was to Benjamin Graham.

In chapter 12 of “The Dhandho Investor: The Low-Risk Value Method to High Returns,” Pabrai used the two gurus to establish his case. He began by noting that Buffett has hosted many university student groups in Omaha, Nebraska, events where students are allowed to ask Buffett any question.

Inevitably, Buffett is asked which books he recommends. He responds that his favorite book was written by his mentor and former employer, Graham: “The Intelligent Investor.” Buffett tells the students there are three key ideas in the book:

1. The analogy of Mr. Market and “Make the stock market serve you.”
2. Buying a stock means buying a piece of a business. That business has an underlying value based on the amounts of cash flowing in and out.
3. Always buy a business for much less than your conservative estimate of its value: Margin of safety.

Buffett also argued that Graham focused on “two joint realities”:

1. The greater the discount to intrinsic value (margin of safety), the lower the risk.
2. The greater the discount to intrinsic value (margin of safety), the greater the return.

That, of course, goes against the grain for many investors and experts because they believe risk and return must move in lockstep. In their view, the only way to increase returns above the market average is to take on more risk, and the only way to reduce risk is to settle for lesser returns.

To illustrate his point, Pabrai turned to Buffett’s investment in The Washington Post in mid-1973. Buffett had agreed with many market observers and experts that the company had an intrinsic value of $400 million to $500 million. At the same time, its market cap based on the share price was just $100 million.

Those other observers and investors found nothing attractive here; after all, they were mostly believers in the efficient market hypothesis. It holds that stock prices convey all relevant facts about all public companies and, therefore, expert knowledge is of no help in generating above-average profits. Buffett, of course, was not a believer, thanks, in part, to the tutelage of Graham.

As a result, he bought a hefty batch of Washington Post stock for about 25 cents on the dollar. As of 2007, when Pabrai’s book was published, Buffett still held every share he had acquired. And why not keep holding them? After 33 years, their value had grown from $10.6 million to $1.3 billion, a “124 bagger” as Peter Lynch would have put it. And that did not include the modest dividend paid by the company.

What Buffett saw in the margin of safety, between market value and intrinsic value, was a gap. Pabrai argued that Buffett expected the gap to close to his advantage. Pabrai added that his own experience had shown that most gaps will close within three years, and that the vast majority of those will close in fewer than 18 months. Applying that standard to the Post case, Pabrai argued his case for buying this way:

• Buffett paid about $6.15 per share for stock he valued at about $25 per share.
• Assume the company recovers 90% of its intrinsic value in three years.
• Assume that intrinsic value increases by 10% per year because of business growth.
• After three years, the share price would rise to about $30 per share.
• That would equal a return of about 70% per year.

Harkening back to chapter 10, Pabrai reintroduced the Kelly Formula, which provides guidelines for how much to buy given a set of odds (applicable to both gambling and investing). The Formula states: “Edge/odds = Fraction of your bankroll you should bet each time.”

Pabrai suggested applying these “conservative” odds to The Washington Post case:

• Odds of a 400% or greater return in three years: 80%.
• Odds of a 200% to 400% return in three years: 15%.
• Odds of 0% (breakeven) to 200% in three years: 4%.
• Odds of a total loss after three years: 1%.

Just a brief reminder, this was well before the internet arrived, when newspapers and broadcast stations were considered pseudo-monopolies, i.e., protected by durable moats.

The Kelly Formula would have recommended investing 98.7% of available capital to this opportunity. Buffett did not go that far, but Pabrai estimated Buffett invested more than 25% of his available cash; he called this a case of Dhandho investing, taking a small risk for potentially high returns. Or, as he frequently wrote, “Heads, I win; tails, I don’t lose much.”

In this case, the “tails, I don’t lose much” was backstopped by the very wide margin of safety: The market price was just above $6 while the intrinsic value was about $25.

Such deals are not common, but they do exist. Sometimes it is a single company that gets into trouble, as was recently the case with Wells Fargo (WFC, Financial), sometimes it can involve a whole sector like retail and companies such as Macy’s (M, Financial), while at other times it can be market-wide distress because of an event such as the dot-com crash in 2000 or the financial crisis of 2008.

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

Read more here:

• The Dhando Investor: 'Investing Is Just Like Gambling'
• The Dhando Investor: Distressed Businesses and Businesses With Moats
• The Dhando Investor: Common Stocks as Existing Businesses

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