Warren Buffett (Trades, Portfolio) incorporates the margin of safety into every investment decision he makes. Benjamin Graham, widely considered the Godfather of value investing, taught the young Buffett the margin of safety principle, and it has remained a crucial part of his strategy ever since.
Graham believed the margin of safety was "the secret of sound investment." Put simply, it is the difference between the price of a stock and its intrinsic value. The margin of safety was designed with one thing in mind: to help overcome the unknown unknowns in the worlds of business and investing. There are many different ways to work out the intrinsic value of a business and, by extension, an appropriate margin of safety, though there will never be one correct answer.
A cushion against mistakes
The margin of safety provides a cushion against mistakes. It also provides a cushion against uncertainty in the valuation. There will always be factors that investors won't be aware of that will have an impact on the stock price or the company's performance.
The margin of safety has many different uses. It is not just applicable to valuing businesses. Individuals might want to use the margin of safety when they are planning their finances.
A core principle of personal finance is to have a savings reserve fund for a rainy day. This is a margin of safety strategy that provides a cushion against unknown unknowns in day-to-day life.
Another principle of personal finance is to try and spend less than a third of one's discretionary income on housing costs. This way if housing costs rise, or discretionary income falls, one has financial flexibility and won't have to move house immediately.
Buffett uses the margin of safety in all elements of his business and personal life, and it has been particularly useful in growing Berkshire Hathaway's (BRK.A, Financial) (BRK.B, Financial) insurance business.
The margin of safety in business
Insurance businesses have to estimate how much money they will eventually pay out to claimants. This is called reserving. One of the most prominent reasons why insurance companies fail is a lack of reserving or incorrect reserving. If a company incorrectly estimates losses, it may have to pay out more than it can afford, which can lead to insolvency.
Buffett has always used the margin of safety to reserve conservatively. On many occasions, Berkshire has taken the worst-case scenario when it has reserved for losses. This gives the group flexibility and headroom if losses become worse than the base case scenario, which is especially important when dealing with the multi-billion dollar reinsurance contracts the group specializes in.
At the 2012 annual meeting, Buffett explained how Berkshire was reserving for a contract with Swiss Re:
"We started seeing mortality figures coming in quarterly that were considerably above our expectations...But until we get — until we figure out what can be done about that contract — and we have some possibilities in that respect — we will keep that reserved at this worst case. And so we took a charge for that amount. We do — we are reinsuring Swiss Re, and then they are reinsuring a bunch of American life insurers, and there is ability to reprice that business as we go along, but the degree to which we and Swiss Re might want to reprice that may be a subject of controversy, we'll see, so we just decided to put it up on a worst-case basis."
Here we see an example of Buffett using the margin of safety in the real world. When insurance companies increase loss reserves, it has a negative impact on the profit and loss statement. Therefore, many companies try to avoid this. Buffett could have tried to reduce reserve loss estimates by improving the figures, but he didn't. This is the margin of safety at work. He knows that if he did, this could lead to further losses down the line. This is just one example of how investors can use the margin of safety in many finance environments.