Robert Abbott

# Is Margin of Safety Enough?

## Unless you have a portfolio full of 'cigar butts,' as Buffett called them, margin of safety likely won't save you in a serious downturn

Over the past five months, I have profiled some 40 gurus listed on the GuruFocus Scoreboard  and become aware of a problem.

Altogether, the Scoreboard is populated by 73 gurus with results for at least 10 years; they are mutual fund, hedge fund and investment managers who rank as the best of the best, based on some current or previous investing achievement.

But of the 73, only 28 have 10-year track records that beat the Standard & Poor's 500 (based on publicly traded funds, before dividends and distributions). In many cases, that underperformance is the result of big losses during the 2008 financial crisis or the pullback in 2015.

While most gurus speak of using risk management – through margins of safety – many appear to have failed to use it effectively.

All of which raises the question: "Is margin of safety enough to protect us against financial storms?"

A loss and recovery visualization

Behind that failed risk management lies some real pain: Getting back to even requires returns that are greater than the amounts lost. For example, a loss of 20% requires a return of 25% to get to break-even again. A loss of 30% requires a return of 43% to return to break-even.

Gerbrandt Kruger, writing for BizNews, provides the following table to show the returns needed for several levels of losses:

Here’s what happens to cause additional grief for investors, as explained by Zack’s: “The math of percentages shows that as losses get larger, the return necessary to recover to break-even increases at a much faster rate.”

Suppose you have a \$100 investment and it declines to \$90. To get back to break-even, you must earn \$10 on the \$90 you have left (not the original \$100). To calculate, use this simple arithmetic: Divide the amount lost by the amount remaining. For example, dividing \$10 by \$90 equals 11%. A return of 11% is needed to overcome a 10% loss. But then the math gets harder, so to speak.

Let’s do the same calculation for a 40% loss (which many investors suffered in 2008): After a loss of 40%, or \$40, on a \$100 investment, an investor has \$60 remaining. The calculation is the same as before: \$40 divided by \$60 = 67%. In other words, the investor who lost 40% needs a positive 67% return to get to break-even, and that’s a challenge.

Notice on the chart above how the losses (in blue) make a straight line as they increase while the recovery values form a curved line as they go up. The recovery line shows exponential increases, not linear. Or, the more you lose, the harder it becomes to get back to break-even.

What’s more, these are amounts investors need to recover before they can get back to building their capital.

For a contrarian view on recovery from losses, see this article by David John Marotta; he argues that recovery is not necessarily as difficult as most pundits (including me) suggest. Still, it must be asked, “Why were there losses in the first place among gurus who promised robust risk management?”

Think of the recovery curve as reverse compounding. When you have positive compounding, you begin to have interest earning interest, a positive leapfrogging process. But when compounding reverses, losses behave like bad credit card debt, to use a different metaphor.

Most of the gurus I profiled promised risk management, primarily by buying stocks with a margin of safety. So why did they lose so much in 2008, and to a lesser extent in 2015?

Evidently, their margins of safety were not robust enough. They appear to have been unprepared, despite the fact some of them made their reputations with huge gains during and after the dot-com bubble. Even those who did not would have been aware of what happened between 1999 and 2002.

Warren Buffett (TradesPortfolio) has been called one of the most prominent advocates of margin of safety, and he’s famous for his first two rules of investing: “Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.” How do we reconcile these two facets of Buffett’s extraordinary investing career?

In a GuruFocus article, Geoff Gannon explained that intrinsic valuation (and by extension, margin of safety) matters a great deal when investors buy for one to five years, or even 10 years. However, he points out that Buffett’s holding periods have grown “very, very long,” which means shifting focus to returns on investment, returns on retained earnings, etc. This explanation allows us to square Buffett’s early endorsement of margin of safety and the dictum not to lose money. A note: While Buffett lost 9.6% in 2008, he has gone on to beat the benchmark over the past 10 years.

From a different perspective, Thomas Macpherson wrote, in a GuruFocus article, “My outperformance over the 10-year period 2006 to 2015 occurred in large part because I lost far less than the Standard & Poor's 500 during the market swoon in 2008-2009. I achieved this by holding far more cash than others.”

And in his book, “Seeking Wisdom: Thoughts on Value Investing,” Macpherson outlined a more robust risk management strategy he uses in his professional capacity as an investment manager. Called “Getting to Zero,” it involves stress testing five critical components of a company’s business: revenue collapses, loss of access to credit markets, bad capital allocations by management, losing a competitive moat and regulatory intrusion by government.

Jae Jun, in an Old School Value blog post, says valuation is important in assessing the margin of safety. But every valuation method has its own assumptions, so he uses as many as seven methods: They are (1) DCF, (2) reverse DCF, (3) the Graham formula, (4) EBIT multiples, (5) absolute P/E, (6) earning power value, (7) a net net calculation.

Finally, note that gurus run large to very large funds, from tens of thousands of shares to millions of shares in each holding. This makes it difficult to move in and out of positions nimbly. For example, retail investors would never move the market by selling a few hundred or thousand shares. But mutual fund managers cannot. They can’t exit a full position easily; they need to feed a relatively small (in the context of their portfolios) number of shares into the market over time. If they’re selling, they need to avoid pushing the market price down and reducing the price on subsequent tranches. If they’re buying, they need to move slowly to avoid pushing the market price up. Many investors watch institutional investors (like mutual funds) closely for signs they are buying or selling.

Not all gurus are created equal

Of the 28 gurus who beat the S&P 500 over the past 10 years, only three did not lose money in calendar 2008:

• Prem Watsa (Trades, Portfolio): The man known as the Canadian Warren Buffett outdid the original Buffett in 2008. He ended the year 21% richer, so to speak, while Buffett ended the year with a 9.6% loss. Watsa is also known as a fanatic hedger. In a 2011 article at ValueWalk, Jacob Wolinsky wrote Watsa is a believer in black swans – once-in-a-lifetime events (such as the 2008 financial bust). As a result, he hedges a lot, or at least he did until the hedges became a significant drag on performance in the past five years. Going into 2008, though, it was a brilliant move. Watsa scored a big gain for the year by purchasing very cheap Credit Default Swaps (CDS) on bonds. Those bonds shot up in value as subprime crisis rolled out.
• John Paulson (Trades, Portfolio) is the second guru to consider, with a gain of 6.3% in calendar 2008. But times have been harder lately, with the New York Times reporting he suffered double-digit losses in 2014, 2015 and 2016. According to Newsweek, he began feeling nervous about the housing market in 2005. He first considered put options but found them too expensive. So Paulson turned to Credit Default Swaps, a bet against the housing market and the broader economy. He also shorted Bear Stearns after listening to a corporate, reassuring presentation that he did not believe. Both bets were highly profitable for Paulson.
• Bill Ackman is the third and final outperforming guru to post a gain in calendar 2008. Again, we see Credit Default Swaps but used this time in a more complex way. Without getting into much detail, Ackman had taken an activist position against MBIA Inc. (NYSE:MBI), the Municipal Bond Insurance Association, set up by several major insurance companies to diversify their municipal bond holdings). MBIA had sold CDS, and Ackman bought CDS against MBIA’s debt. In 2008, MBIA crashed, and Ackman made a small fortune selling those CDS.

Obviously these three gurus have Credit Default Swaps in common. But perhaps more importantly, all three had done an excellent job of reading the market and correctly assessing its susceptibility to flaming out.

Conclusion

Margin of safety was one of the key ideas articulated by Benjamin Graham, the father of modern value investing. Almost all GuruFocus gurus have also put it to the fore in describing their investing styles.

Theoretically, buying low, holding for a few years and then selling should produce high average annual returns. Yet, as we have seen, few gurus can beat the S&P 500 benchmark, despite adhering to their self-imposed margins of safety.

Does this mean margins of safety are not enough to protect stocks and portfolios? Perhaps.

Perhaps a holding period of two, three, five and even 10 years is not long enough for margins of safety to work effectively. As we saw in the article about Buffett’s extended holding periods (now often more than 20 years) may be the difference. Over lengthy periods of 15, 20 years or more, compounding may have enough power to overcome limitations to the margins of safety.

It’s also worth noting that the three outperforming gurus who made it through 2008 without a loss were asking the right questions. Instead of focusing on a big pullback as a means to buy new stock at a discount, they were seeing the bigger picture, and asking, “How do we preserve our capital so we can afford to buy liberally when the next big decline hits?”

No doubt the debate about effective methods of risk management will continue, but for now, it seems safe to say that margins of safety, on their own, are not enough to protect against the next big slump.

Disclosure: I do not own stock in any of the stocks listed in this article and do not expect to buy any in the next 72 hours.

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995, and in 2010 added options, mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the Unseen Revolution. In Big Macs & Our Pensions: Who Gets McDonald's Profits?, he looks at the ownership of McDonald’s and what that means for middle class retirement income.

In an eclectic career, Robert Abbott was a radio news writer and announcer, a newsletter writer and publisher, a farmer, a telephone operator, and a construction worker. When not working, he has been a busy volunteer, which includes more than a decade of leadership roles at the Airdrie Festival of Lights, one of North America’s leading holiday light displays. He lives in Airdrie, Alberta, Canada.

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LwC - 9 months ago    Report SPAM

Hi Mr. Abbott:

I can think of a few other possible reasons why the investment managers who claim to follow Graham’s recommendation to allow for a margin of safety, failed to beat the index. For example:

1. Their estimates of intrinsic value was not a good estimate;

2. They did not allow for a large enough margin of safety;

3. Perhaps most misleading of all, they might only give lip service in their marketing materials to their claim to follow Graham’s “value investment” process, but in fact do not follow it very much, or even at all.

Excerpted from Benjamin Graham on Value Investing, by Janet Lowe:

SUBTLE MISINTERPRETATIONS

Like so many other profound works, more people seem to pay lip service to The Intelligent Investor and Ben’s [Graham] other books than actually read them. As William Ruane is quick to point out, there are many misinterpretations of Ben’s teachings. Graham himself once said that his books “have probably been read and disregarded by more people than any book on finance that I know of.” Some of the ignored or misunderstood points are subtle but important.

Robert Abbott - 9 months ago

Hi LwC: Thanks for your comments! I agree with all three of your points about investment managers and margins of safety. I particularly liked your reference to the Janet Lowe book, I will put that on my reading list.

Dr. Paul Price - 9 months ago    Report SPAM

"Fluctuations", even extremely negative ones don't mean you lost money. Your account value went down a lot in 2008 but if you didn't sell, or bought more, you were able to make good profits.

Your math examples showing how much it takes to recoup losses misses the converse effect. Once a stock has fallen 50% a simple return to its starting point represents a 100% gain for someone who is first buying in.

Most experts view "margin of safety" as insurance against permanent loss of capital- not changes in market price.

Asking that equity managers showed positive returns in 2008 is holding them up to the wrong standard. Unless you were short it wasn't possible to gain in a diversified portfolio that year, even for the best stock pickers.

They got rewarded in spades during 2009 and the years that followed.

Robert Abbott - 9 months ago

Thanks for you thoughts, Paul! I would disagree about your last point. Of the 73 gurus with public records, 45 (62%) failed to beat the S&P 500 over the past 10 years, and from my perspective, the only reason to invest with a guru is because you want to beat the benchmarks.

LwC - 9 months ago    Report SPAM

@Mr. Abbott

FWIW here’s what Seth Klarman (Trades, Portfolio) has to say about what he calls “value pretenders” in his book Margin of Safety:

Beware of Value Pretenders

"Value investing" is one of the most overused and inconsistently applied terms in the investment business. A broad range of strategies make use of value investing as a pseudonym. Many have little or nothing to do with the philosophy of investing originally espoused by Graham. The misuse of the value label accelerated in the mid-1980s in the wake of increasing publicity given to the long-term successes of true value investors such as Buffett at Berkshire Hathaway, Inc., Michael Price (Trades, Portfolio) and the late Max L. Heine at Mutual Series Fund, Inc., and William Ruane and Richard Cunniff at the Sequoia Fund, Inc., among others. Their results attracted a great many "value pretenders," investment chameleons who frequently change strategies in order to attract funds to manage.

These value pretenders are not true value investors, disciplined craftspeople who understand and accept the wisdom of the value approach. Rather they are charlatans who violate the conservative dictates of value investing, using inflated business valuations, overpaying for securities, and failing to achieve a margin of safety for their clients…

Robert Abbott - 9 months ago

Thanks, LwC. As you likely know, Klarman has a record that gives his words credence. Since I've been watching the Scoreboard, he has had the second or third best record in beating the benchmark.