Margin of Safety is at the centre of how we invest for our clients. “When you build a bridge, you insist it carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And that same principle works in investing.” – Warren Buffett.
Margin of safety involves purchasing a security when its market price is substantially below its intrinsic value. That brings us to the question of ‘What is intrinsic value?’. Intrinsic value can be defined as the sum total of all the free cash flows that accrue to a company upto infinity, discounted to today at an appropriate discount rate. We have defined these terms in prior newsletters – so we will not dwell on their meaning here. Just as important as the quantum of free cash flows, is the certainty of receiving them.
Margin of safety, in some sense, means being conservative about the assumptions that you build into the buy case for any particular security. It means not building rosy projections about the future to justify a current price which may often be too high.
Margin of safety extends, for us, to the quality of businesses that we invest in. A poor-quality business, no matter how attractively priced, can be a minefield sometimes. Firstly, time is the enemy of the poor-quality business while it is a friend of the good quality business. With passing time, the poor-quality business will deteriorate in value and even if you are able to generate a satisfactory return over the long term, the time period it takes for the market to appreciate such a business, can be awfully long and can test your patience and the eventual return. In the current environment, of course, a number of businesses, particularly small caps, whether of mediocre quality or exceptional quality, have been bid up considerably but such periods do not last indefinitely as reality will, sooner or later, catch up with prices.
Our investment philosophy rests on risk minimization rather than return maximization. It’s a different matter that we have performed reasonably well over time, but our attitude to investing is that of safety first. We have reiterated in many of our conversations with you that protection of capital is our Goal No 1 and we take this very seriously. Sometimes, you may find that we are somewhat underperforming the market during strong bull markets, where the margin of safety has diminished in the market place. Our real value to our clients becomes more obvious over a full cycle of the market and our historical track record is testimony to that. We have had only 2 negative performance financial years (April to March) in our history when the Nifty has had 4 such years. Even the quantum of fall, in the negative years, has been less than the Nifty. The way arithmetic works is, that if you fall less, then even when you grow slightly less in subsequent years, you come out better. This strategy of risk minimization helps our clients sleep better and stay through the course of volatility in markets and enjoy the benefit of long term growth in their portfolio.
We believe that there is less margin of safety in the current environment and we have over time, shepherded our portfolio into the safer end of our investment universe, based on the risk reward that the different stocks provide us.