In the final chapter of “The Intelligent Investor,” Benjamin Graham wanted to distill the lessons of this book into one phrase:
"Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY. This is the thread that runs through all the preceding discussion of investment policy—often explicitly, sometimes in a less direct fashion."
Margin of safety for bondholders and preferred stockholders
For experienced bond investors and preferred stock investors, what counts is the past ability to earn more than interest requirements; this margin of safety protects investors against some future loss in net income. If the margin is small, then investors must carefully project future income. If the margin is reasonably large, then investors can rely on previous performance.
To calculate the margin of safety for bonds, Graham compared the total value of the issuing company with the amount of debt. For example, if a business owes $10 million in bonds and is “fairly” worth $30 million, then the company can shrink by two-thirds before bondholders take a loss. The cushion, between the value of bonds and the fair value of the enterprise, can be estimated with the average market price of the junior (common) stock issues over a number of years. Average stock prices generally reflect average earnings power.
Margin of safety for common stocks
Graham considered situations in which a common stock might be considered sound: when it registers a margin of safety as strong as that of a good bond. Such situations occur when:
- The company has only issued common stocks.
- In depressed conditions, the stock sells for less than the total of bonds that could be issued against its property and earning power.
Finding such bargains means having the margin of safety of a bond, plus the potential for higher income and the capital gains inherent in stocks. When a common stock is bought in normal conditions, investors will expect the margin of safety to come in the form of expected earnings power.
The biggest risk facing investors, and the one that had hurt them most, came from buying low-quality securities when business conditions were favorable. Buyers assumed the current good earnings originate with the company and confuse that seeming prosperity with safety. In such favorable times, companies can sell bonds and preferred stocks of inferior quality, as well as float the common stock of “obscure” companies at premium prices, based on just a few years of strong growth.
Graham saw a parallel between the practice above and the practice of investing in growth stocks. Buyers of those stocks relied on future earnings power that was greater than historical earnings power.
Margin of safety for undervalued stocks (bargains)
Graham started by defining an undervalued or bargain stock as one having “a favorable difference between price on the one hand and indicated or appraised value on the other.” That difference is the margin of safety, and there are implications:
- The margin is available to compensate for “miscalculations or worse than average luck.”
- Buyers emphasize “the ability of the investment to withstand adverse developments” since they are not overly enthusiastic about the company’s prospects, within limits.
When investors move into the realm of undervalued or bargain stocks, it is assumed they are enterprising investors. As we’ve seen elsewhere in the book, Graham recommended defensive investors stick with bonds, plus large companies that had a history of earnings growth and had paid a dividend for many years. Enterprising investors should start with a defensive portfolio, and then diverge from it when they have a strategic reason. One of the main reasons would be to gain additional returns by carefully investing in undervalued stocks.
Diversification
Following up on bargain stocks and the margin of safety, Graham added another connection: diversification, as one is correlative with the other.
Margin of safety, by itself, is not enough since individual stocks may fare badly (they may be undervalued for good reason). In this case, “the margin guarantees only that he [the investor] has a better chance for profit than loss—not that loss is impossible.”
As the number of bargain stocks increases, however, “the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses.” Graham cited this same principle as being the basis of insurance underwriting. For math enthusiasts, he illustrated this principle with the arithmetic of roulette.
Investment versus speculation
In this section, Graham argued the margin of safety concept might be used to distinguish investment from speculation.
Unknowing speculators might think they are investing because they believe the time is right, their skills are superior to those of the crowd or their advisor or system is trustworthy. Graham was not convinced, however, and wrote that such beliefs are subjective and not supported by evidence or reasoning.
A true investor uses simple and definitive arithmetical reasoning from statistical data to identify a margin of safety—a quantitative proof:
“Thus, in sum, we say that to have a true investment there must be present a true margin of safety. And a true margin of safety is one that can be demonstrated by figures, by persuasive reasoning, and by reference to a body of actual experience.”
Extending the concept of investment
Graham rolled out yet another implication of margin of safety by distinguishing between conventional and unconventional investments. Conventional investments are appropriate for defensive investors and included stocks of high-quality, dividend-paying companies.
Unconventional investments are for enterprising investors and include undervalued common stocks of secondary companies—provided they can be bought for two-thirds or less of their indicated value. The extension, then, was that a “sufficiently” low price can convert a mediocre stock into a good opportunity, assuming investors are informed, experienced and diversified.
“For, if the price is low enough to create a substantial margin of safety, the security thereby meets our criterion of investment.”
Summing up
In his windup, Graham said “Investment is most intelligent when it is most businesslike.” He offers four principles:
- Know your limits and know what kind of business you are running; defensive investors should not stretch for yield, and enterprising investors should know their securities as well as another type of businessperson knows manufacturing, retailing, etc.
- It’s your business, so you should manage as you would manage a company of your own. Refuse to let anyone else run it unless you can adequately supervise, and you have confidence in the ability and integrity of the would-be manager. In other words, be sure you are buying a company with good management.
- Do not go into any business, including investing, without “a reliable calculation shows that it has a fair chance to yield a reasonable profit.” Opportunities for profit should be based on arithmetic and not optimism. Do not risk a substantial part of your principal.
- The crowd may disagree with you, but stick to your strategy based on your knowledge and experience. If your conclusion is based on facts and sound reasoning, act on it.
These were Graham’s final words in the final chapter:
“To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks.”
Conclusion
With this final chapter, Graham wrapped up a broad, systemic review of investors and investing. And having provided that big picture, he also delved into the specifics of everything from dividends to speculation.
The result? A highly rational set of strategies for investors. For those short of time, knowledge and experience, Graham recommended a defensive strategy, one in which risk is minimized and returns are expected to be average. For enterprising investors, he laid out a strategy for diverging from a defensive portfolio.
To manage risk while diverging and seeking above-average returns, enterprising investors should focus first on the margin of safety and on diversification. Graham saw such stretch investing as somewhat similar to the business of insurance underwriting.
Much of what Graham taught us in this book has become embedded in the canon of investment knowledge. Value investors know of margin of safety and diversification, even if they do not know from where it came. All investors have benefited greatly since the first edition of this tome came out in 1949, and it should not be forgotten.
I highly recommend “The Intelligent Investor,” which is readily available at bookstores.
(This review is based on the 1973 revised edition of “The Intelligent Investor”; republished in 2003 with chapter-by-chapter commentary by Jason Zweig and a preface by Warren Buffett (Trades, Portfolio). For more articles in this series, go here.)
