Cornerstone 2: Margin of Safety, Thank You Benjamin Graham
This cornerstone is one of the most important principles that can be applied to investing. This is an engineering concept describing the structural capacity of a system beyond the expected loads or actual loads. Benjamin Graham was one of the founders of this concept as it applies to investing. It is a very simple concept and can be applied to anything.
Let’s first take a simple hypothetical explanation of the concept, applied to white water rafting. Say you could go rafting without a life jacket. That make excite some thrill seekers, but the average person will want that life jacket. In this situation, that lifejacket has a margin of safety component. Many other factors come into play that increase or reduce the margin of safety. Can the person swim? If so, how well? Where does the chosen river fall in the rating scale, a Class I or Class V? If you are a good athlete or expert swimmer, wearing a life jacket, and rafting on a Class I rapid, there is a larger margin of safety. Each component that is taken away decreases your safety. On the flip side, if you can’t swim, don’t wear a life jacket, and are rafting on Class V rapids your margin of safety is a bit smaller. In this case, each component that is added decreases your safety.
Now let’s apply the concept to purchasing a business. There are several factors that play into the margin of safety. Price, terms, leverage, legal exposure, and due diligence are just a few. Let’s take another hypothetical situation and compare: two buyers each want to purchase a business. Everything is exactly the same except for their legal exposure. Buyer 1 bought the business properly, owns 100%, and has personally guaranteed all of the financing. Buyer 2 bought the business properly, owns 75% of it, and has a strong financial partner for the remaining 25%. Additionally, the financial backer has guaranteed all of the financing so that they are not personally exposed if the wind changes directions. After all, no one goes into a venture thinking that it is going to fail. Buyer 2 will be much better off, as his margin of safety is larger and he is aggressively protecting the downside.
In our world of commercial property, companies usually overestimate rents and underestimate expenses. Wanting to get into a deal so badly that facts are ignored is foolish. It is better to not get into a deal at all than to get into a bad one. A margin of safety is a way to keep emotions out of the purchasing process. Internally, we as a company take our investment criteria and add this component to the mix. We look at many variables, but for simplicity sake, let’s look at rents and expenses. We do our rent analysis and deduct rents by 20%. With expenses, we raise them by 20%. If the numbers still work with these two components, it is a winner. If they don’t, the deal dies.
Simple concepts are often over-complicated. The nice thing about the margin of safety concept is that it can be applied to everyday life. Taking something that is applicable on a daily basis is easier to master over time, which can create wealth and keep investors from entering into bad ventures.
This is the 2nd of 12 articles on the cornerstones of investing. Keep your eyes peeled for Cornerstone #3.