chapter 20_margin of safety concept and more notes

8/10/2019 Chapter 20_Margin of Safety Concept and More Notes

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Lecture 1 for Lesson 1, Readings: Margin of Safetyand Mr. MarketfromThe

Intelligent Investor, Preface fromthe book, Deep Valueby Tobias Carlisle, and

Behavioral Portfolio Management.

Supplementary readings: Quantitative Value, Margin of Safety(Klarman) Value

Investing(Montier) and for special projects.

--

Tan!s for tose "o sent teir ans"ers. #our replies elp me assess "o is in te

class. $e a%e almost &'' students enrolled and many seem !no"ledgeable and

astute. f you reuest someting or as! a uestion and don*t respond , please place

in block letters in an email to [email protected], S!"#$ R%&S'.

Typically, respond "itin + ours, but recei%e undreds of emails, so don*t ta!e it

personally if am slo" to respond or your email reuest is lost.

-et*s sit do"n and discuss "y sent you tese readings.

All intelligent investing is value investingacquiring more than you are paying for.

ou must value the !usiness in or"er to value the stoc#. $%harlie Munger.

tin! of in%esting as trying to buy bargains typically "en oter in%estors feel, need,or must sell urgently. f (e are correctin our assessment of intrinsic %alue, (/0)11

de2ned troug future discounted cas 3o"s or pri%ate mar!et %alue bet"een t"o

cogent in%estors11ten Regression to the )eansould "or! o%er a reasonable

time to close te gap bet"een te price "e paid and /. 4ote tat 5raam 46/67

discussed o" to calculate intrinsic %alue. /aluation is subject to judgment and it is

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often a range of %alues depending upon our assumptions and cost of capital. ften

"e can*t %alue a company because of our lac! of e;pertise. Te mar!et pro%ides a

place "ere prices are oe on tose

distortions. n oter "ords, "en people go cra>y, "e see! to ta!e ad%antage. ?ut

people o%er1react, go cra>y, fear loss, see! out certainty, and erd togeter because

tey are uman, but so are "e. $at ma!es us so special@ $on*t "e fall prey to

tose same biases@ $e "ill e;plore tis furter in te course.

+hat is alue nesting/

f you as!ed Aon 4e


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of Mean 7e%ersion "or!s, ten can "e pro2t on a ris!1adjusted basis@ Bt te end of

tis course, "e sould be able to ans"er tat uestion. Bny one of our in%estments

may go to '.'' ($at did ?u


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8.'' +.&'

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8.'' 8.&'

+'.''+.

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++.&'D

)* goals for students are:

0ou and 2 are the enem* tus "e need to build protections against our 3a"s.

n%esting often goes against te grain of o" our brains e%ol%ed. See te grass

rustle, a tiger lur!s. 9on*t tin! about itJ7E4G See te plunging price of my stoc!,

sellG $e are ard"ired to react ECK-# to danger or else "e "ouldn*t be ere (our

ancestors "ouldn*t a%e passed on teir genes). 7ecogni>ed tat "e are as 3a"ed,

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fearful, opeful, and subject to emotion as oters. $e must 2gure out a "ay to "or!

around our natural instincts. ?u


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or e;ample, since deep %alue in%esting may be igly counter1cyclical to te general

mar!et, you may "idely underperform0 a bencmar! inde; for a long period of time.

Te patience reuired is diNcult and uncertainty is often confused "it ris!.

Riskis meaningless "itout a preceding adjecti%e. 7is! is not %olatility (unless you

are ea%ily le%eraged). 7is! could be: operational, political, management, or 2nancial

ris!. r te ris! could be #EJyour emotional state, your ubris, and=or

undisciplined actions.

Students sould reali>e tatinesting is simple but not eas*. Prof. Aoel5reenblatt in is M?B class and is boo!, &he 'ittle Boo# that Beats the Mar#et (to be

emailed later) says tat all e does is 2gure out "at a business is "ort and ten

pay a "ole lot less for it. Seems simple but o" to go from ere to tere@ Prof.

5reenblatt also says e is not better at analy>ing companies tan many $all Street

analysts but e !no"s "at e !no"s (is circle of competence) and e "eigts

mispriced bets. $en e often can*t %alue a company, e mo%es on. n%esting is

someting you "o(or not do until you do decide to act). Bs an in%estor al"ays

consider (ho is on the other side of the trade from *ou so you don*t become

te patsy or fool at te po!er table. B fool ceases to be a fool "en e or se

uits=corrects te mista!e. Te deep %alue in%estor is see!ing out mispriced

securities o"e%er tat is determined.

Many readers say teir goal is to become better at determining intrinsic %alue (/0)

because ten tey "ould a%e te !no"ledge and con2dence to buy and sell "en

prices mo%e a"ay from /. F$6/67O.

My bias is tat it is 4T diNcult to 2nd price belo" %alue "en tere is etreme

panicor distress on te part of sellers, but te diNculty lies in BCT45 to sei>e te

opportunity. 6%en 966P /B-E6 in%estors are uman "it all te same biases as

oters. $en te company*s stoc! is plummeting, analysts are do"ngrading teir



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earnings estimates, te ne"s for te industry*s future is terrible, and ten peraps,

"e fear, te %alue "e see isn*t tere. ur fears o%ercome us. $e "ill "ait until "e

gain more certaintyJ"e practice 76B7/6$ in%esting. $e become part of te same

erd tat "ill act emotionally to pro%ide us "it mispricing. $al!ing across a plan!

isn*t ard, but "en tat plan! is perced bet"een t"o cli


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>rice?intrinsic value.

(hat are investors rewarded for3

@potting mispriced securities.

(hat concept must you truly grasp to be a successful deep value investor3

!argin of @afety.

(hy do prices move more than intrinsic value3

$uman psychology, namely fear and greed.

True or False ; good value investor understands and takes advantage of the behavioral

biases of others because he has already eliminated them in him?herself3

True.

2eep value investing often means buying distressed assets but can you buy a franchise

(see attachment of Wal-Mart or a company able to grow with profits above its cost of

capital due to barriers to entry) at deep value prices?Aame two investments by Buffett

that might fit that criteria3 (!TC'& 4ear @=D Dhart

Doca-Dola

@anofi

$ow can we think of activist investing3

;ctivist help reveal mispricing by spotting ever misallocated capital, restructuring potential or mispriced

assets cash, other assets7.

(hat are your goals for this course3

Becoming a better investor, especially regarding the determination of intrinsic value.

$ow do !r. Eraham and !r. Buffett view buying a share of stock3

-ecture R for 9eep /alue """.csin%esting.org
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It5s a piece of a business.

(hat do you do if you can5t find an attractive investment3

hiladelphia it5s worth fifty Bucksvideo7

Dash is king. The seller is desperate for cash. The buyer has no rush to buy.

;re prices based on sub:ective or ob:ective valuation3

@ub:ective valuation.

If you are playing poker and you don5t know who the sucker iswhy is that a problem3

(ho5s the sucker3 >laying the sucker video7

!alkovitch.

(hatEMOTO!"# error did the $%&'E display3

Gverconfidence.

(hen did the sucker DH;@H to be a sucker3

Ao idea. (hen he realied he had the wrong process3

(hat is the main errorJman, especially male, beginning investorsexhibit3

Donsidering the market is a 8weighing machine9 while it5s a 8voting machine9.

(hat is the key to investment success3

@potting mispriced securities.

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(hat T4>H of market participant seeks !r. !arket for investment guidance3 2o you

notice any conflicts, ironies or problems3 Gr can it be a way to improve your investment

results3

@peculators seek !r. !arket for investment guidance.

$ow do many investors react to huge market volatility3

They sell when prices fall, and buy when they rise.

2id !r. Eraham give you a way to access the valuation of a common stock3 Hxplain.

Etra credit*2id Eraham evergive a FG=!K/; for determining intrinsic value3 Be

carefuland read the footnotes to the formula he presents and why he offers it to readers. @ee

Intelligent Investor.

For the * previous Luestions rather than a formula, in my opinion, Eraham gave more an investment

guidance assess the earnings power of a stock earnings yield for instance7 and compare it to a more

secure securities bond of high Luality companies7.

(hat is the biggest mistake investors make when buying securities3 $ow would you

prevent that3 (hat does Eraham do3

They don5t forge their own view of the value of a stock and they don5t buy with a margin of safety.

(hat is the danger in growth stock investing3

Aot paying attention to the Luality of the stock and considering past growth as a trend for future

forecasting.

(hat is a good or bad stock?investment3

; good investment usually displays a comfortable margin of safety that protects from estimation error.

(hen during the past fifty years were the greatest ;merican companies Franchises mostly7

bad investments. (hy3

2uring the Aifty Fifty period, when the market priced an infinite blue sky scenario for stocks that already

traded at steep valuation multiples.



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Editor

Morningstar France

+33 (0)1 55 50 13 12 voice

+33 (0)6 80 20 6 !5 "o#ile

+33 (0)1 55 50 13 25 $a%

&ocelyn'&ovene"orningstar'co"

52 re de la *ictoire ,500 -aris

Everyt.ing Morningstar'

MORNINGSTAR AWARDS 2015

Jedi 12 "ars 2015 / 1"edition

a cr"onie de r$rence de lindstrie de la gestion

.is e4"ail contains rivileged and con$idential in$or"ation and is intended only $or t.e se o$ t.e erson(s) na"eda#ove' ny disse"ination distri#tion or dlication o$ t.is co""nication 7it.ot rior consent $ro" Morningstaris strictly ro.i#ited' $ yo .ave received t.is "essage in error lease contact t.e sender i""ediately and deletet.e "aterials $ro" any co"ter'

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Do you agree that "eep value investing is an investment triumph "isguise"

as )usiness "isaster*

Bgreed but "it a major ca%eat.

9eep /alue relies on + aspects. irst is te possible in%ol%ement of acti%ist in%estors

to enter at distressed earnings and impro%e te poor management and lead to a

cange and second is te natural la" of re%ersion to mean e%en "itout te presence

of acti%ist in%estor. Since te cause of depressed earnings can be operational ("ic

can be impro%ed "en an acti%ist in%estor "it a good past record of turning aroundcompanies enters te company or e%en treatens to o%er tro" te e;isting

management) or en%ironmental ( in case te company is going troug tail"inds and

te price as fallen "ay belo" "at earnings justify), it pro%ides an in%estor a

tremendous amount of safety in purcase of suc depressed entities.

Ca%eat ne: Bcti%ism is not pre%alent in all te countries and one as to be %ery

cautious of follo"ing tis strategy in all type of countries. Te judiciary, regulatoryand legal structure of te countries as to support te acti%ism is order for tis to be

a model to rely on. ?eing from a country li!e ndia and !no"ing fe" people "o a%e

attempted in past, its far more diNcult to practice it ere so most of te 9eep /alue*

teme companies can end being a %alue trap since majority euity is eld by

promoters "o can !eep te barbarians a"ay from te gate using means "ic are,

strictly spea!ing, not legal or moral.

What "o you see as the )iggest investment risk+s, in -"eep value

investing*



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1 Concentration of portfolio in select fe" deep %alue stoc!s. t as to be di%ersi2ed

enoug if te in%ol%ement is limited to ta!ing small minority sta!es and not actually

becoming te agent of cange. 9i%ersi2cation also ta!es care of te errors of

judgment and gaps in industry understanding and "orse tan a%erage luc!

1 -ac! of near permanent capital*: n%esting in deep %alue needs patience because te

actual turnaround time is near impossible to predict. f one depends on te capital

tat is in%ested, one may 2nd it diNcult to ma!e pro2table in%estments from 9eep

/alue in%esting.

1 4ot selling at an appropriate time (Bppropriate time is %ery diNcult for me to

describe ere in "ords. ?ut as a general rule, if it crosses te iger estimate of your

intrinsic %alue range calculation, you sould sell. ts more indi%idualistic a decision

tan any)

Since te uestion only as!ed for n%estment ris!s, am ignoring te psycologicalfactors in te ans"er

When "o stoks appear most attrative an" /hen is the risk highest*

Temporary Tail"inds or blood on te street usually lea%es stoc!s muc ceaper and

attracti%e. nacti%ity on macro front also tires up in%estors and lead to irrational

selling.

n te oter and "en te best case scenarios (earnings in te pea! cycle of

business) are considered as norm and discounted in prices, to enter ten is te

ris!iest proposition.

What is onsi"ere" the main margin of safety metri*

9i


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or being rigt and di


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Bmerican 6;press and Salomon ?roters as per me

Fo" can "e tin! of acti%ist in%esting@

Bs said earlier, perating in a country li!e ndia, Bcti%ism is ris!y and a deep poc!et

play but for a indi%idual small in%estor, e can bring te companies to notice and

see! to bene2t from in%ol%ement of acti%ist in%estors.

6iter be te cangeL dri%e te cange or at1least bringing it to notice of someone

"o can.

$at are your goals for tis course@

7e%ise, re1learn fe" tings, un1learn some crap may a%e gotten in my ead in

tese years and loo!ing from fres perspecti%e again.

Fo" do Mr. 5raam and Mr. ?u


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To ser%e an in%estor.

Fo" are prices set@ in Piladelpia it*s "ort 2fty ?uc!s(%ideo)

9emand and Supply euation based on perceptions of reality of te mar!et

participants

Bre prices based on subjecti%e or objecti%e %aluation@

Subjecti%e: n te basis of perceptions tat dri%es te so called objecti%e %aluations

based on e;cel seet calculations (pysics en%y)

f you are playing po!er and you don*t !no" "o te suc!er isJ"y is tat a

problem@ $o*s te suc!er@ Playing te suc!er (%ideo) $at )"'"#8L error

did the S&!9R displa*@ $en did te suc!er C6BS6 to be a suc!er@ $at is te

main errorUman, especially male, beginning in%estorsJe;ibit@

a) Tat*s a problem because it so"s one*s inability to read te people and sta!es "ic

is essential in po!er.

b) 6motions as per te cards dealt, o%ercon2dence in is game and assuming oters to

be suc!ers.

c) 4e%er ( or "en e is out of tat game )

d) %ercon2dence in o"n ability and confusing luc! "it genius.

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$at is te !ey to in%estment success@

S/inging the pith /hen the o""s are in favour +margin of safety, an"

playing the game long +Compoun"ing,

$at T#P6 of mar!et participant see!s Mr. Mar!et for in%estment guidance@ 9o

you notice any con3icts, ironies or problems@ r can it be a "ay to impro%e your

in%estment results@

1 n%estors "o don*t do teir o"n "or! and a%e little independent opinions.

1 Tey see! te guidance from te mar!et to beat te mar!et. Irony **

1 4ot as per me.

Fo" do many in%estors react to uge mar!et %olatility@

?uying and selling at "rong timings ( Too muc acti%ity)

Mista!ing Price to be te barometer for company*s performance (confusing %olatility

"it ris!)

9id Mr. 5raam gi%e you a "ay to access te %aluation of a common stoc!@

6;plain.

Te "ay 5raam tal!s about %aluation is to loo! at te assets and %alue tem in

order of teir surety as an asset. or e;amples : Te most predictable and sure1sot

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-etting te Price and %olatility to dri%e te buying bea%ior.

5raam ensured margin of safety as sacrosanct and di%ersify to reduce te ris!.

pre%ent tat by !eeping a "atc on te performance of te companies aminterested in and buying tem "en tere are temporary tail"inds or e%ents tat

a%e more e


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9o not follo" Bmerican Mar!ets, Bll my ans"ers "ill be based on google searc and

dri%en by indsigt bias so "ould refrain from ans"ering tis.

$at is te best approac to ta!e in in%esting@

n%est "it Margin of Safety

$at is ris!@

7is! is not !no"ing "at you are doing and ence increasing te probability of

permanent loss of capital.

$y do so many smart0 people fail at in%esting or at least do less "ell tan

simple stoc! inde;es o%er time@

"reed and #ear. $ot sticking to one investment philosophy and being continuously guided by the

market.

$at are te 2%e in%estment criteria in te 4ehaioral 3ortfolio

)anagement/

$iidends

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8nal*sts arning stimates

=igh $ebt !ompanies

#egatie #et +orth

3rice to Sales

$at is te cult of emotion@

Mar!ets are referred to as Cult of emotions as prices are dri%en by emotion

s it possible for emotion to elp you as an in%estor@

$ell, oter people*s emotions certainly do. Te "ole idea is to bet against tecro"d "en te odds are in your fa%our.

11

2o you agree that deep value investing is an investment triumph disguised as business disaster3

;s my experience with investing started five years ago I can only say that panic is the best time to buystocks.

(hat do you see as the biggest investment risks7 in 8deep value investing39

Hven if you buy at a big discount, if the industry is bad like the textile business that Buffet bought andlater sold7 or if the managers turned out to be dishonest or inexperienced for example they don5t knowhow to integrate a new company after a merger7 you can still lose money.

(hen do stocks appear most attractive and when is the risk highest3

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They appear most attractive when the discount is the biggest. The risk is highest when the company is atthe beginning of the cycle when earnings are the peak.

(hat is considered the main margin of safety metric3

The discount to intrinsic value.

(hat are investors rewarded for3

They are rewarded for discovering mispricing opportunities between intrinsic value and market value.

(hat concept must you truly grasp to be a successful deep value investor3

Intrinsic value.

(hy do prices move more than intrinsic value3

Because !arket is driven by emotion.

True or False ; good value investor understands and takes advantage of the behavioral biases of othersbecause he has already eliminated them in him?herself3

False. (e all have biases and the way I try to eliminate them is using an investment checklist.

2eep value investing often means buying distressed assets but can you buy a franchise see attachmentof (al-!art or a company able to grow with profits above its cost of capital due to barriers to entry7 atdeep value prices3 Aame two investments by Buffett that might fit that criteria3 (!TC'& 4ear @=D Dhart

;mex and Eillette.

$ow can we think of activist investing3

;s a way to good buy companies that have been under performing their peers for some years and need achange in management to catch up with benchmark. Icahn, Bill ;ckman and Dhris $ohn are goodexample of activists.

(hat are your goals for this course3

Dontinue learning value investing and meet interesting investors

$ow do !r. Eraham and !r. Buffet view buying a share of stock3

;s a stake in a business.

(hat do you do if you can5t find an attractive investment3

$old the cash and wait for the opportunity to come.

(hat is !r. !arket5s purpose3

@et prices based on emotion

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$ow are prices set3 in >hiladelphia it5s worth fifty Bucks video7

Based on the perception of the buyer for how much he can re-sell the asset, supply?demand7.

;re prices based on sub:ective or ob:ective valuation3

>rices are based on sub:ective valuation of future growth earnings prospects.

If you are playing poker and you don5t know who the sucker iswhy is that a problem3 (ho5s thesucker3 >laying the sucker video7 (hat H!GTIGA;/ error did the @KDH of market participant seeks !r. !arket for investment guidance3 2o you notice any conflicts,ironies or problems3 Gr can it be a way to improve your investment results3

!anic depressive and irrational participants.

$ow do many investors react to huge market volatility3

They react in extremes by selling if market is going down or by buying if going up.

2id !r. Eraham give you a way to access the valuation of a common stock3 Hxplain.

4es, by inverting >?H, comparing it to treasury bonds and determine margin of safety

Hxtra credit 2id Eraham ever give a FG=!K/; for determining intrinsic value3 Be careful and read thefootnotes to the formula he presents and why he offers it to readers. @ee Intelligent Investor.

;verage H>@ for the last ' years divided by share price should give return higher than treasury bonds

(hat is the biggest mistake investors make when buying securities3 $ow would you prevent that3 (hatdoes Eraham do3

Biggest mistake is buying when earnings are at peak. >revent by buying at a big discount. Eraham buysat the end of cycle when earnings are lower.

(hat is the danger in growth stock investing3

It ignores reversion to the mean, competitors and it is based in future prospects.

(hat is a good or bad stock?investment3

>rice paid determines the rate of return.

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words, we venture the motto, M!GI" #$ S$%&'.1This is the thread that rounds through all thepreceding discussion of investment policyoften e!plicitly, sometimes in a less direct fashion. "et usnow, briefly, to trace that idea in a connected argument.

#ll e!perienced investors recogni$e that the margin of safety concept is essential to the choice of soundbonds and preferred stocks. %or e!ample, a railroad should have earned its total fi!ed charges better than

five times &before income ta!', taking a period of years, for its bonds to (ualify as investmentgradeissues. This past ability to earn in e!cess of interest re(uirements constitutes the margin of safety that iscounted on to protect the investor against loss or discomfiture in the event of some future decline in netincome. &The margin of above charges may be stated in other ways)for e!ample, in the percentage bywhich revenues or profits may decline before the balance after interest disappears)but the underlyingidea remains the same.'

The bond investor does not e!pect future average earnings to work out the same as the in the past* if hewere sure of that, the margin demanded might be small. +or does he rely to any controlling in hisudgment as to whether future earnings will be materially better or poorer than in the past, if he did that,he would have to measure his margin in terms of a carefully projectedincome account, instead ofemphasi$ing the margin shown in thepastrecord. -ere the function of the margin of safety is, in essence,

that of rendering unnecessary an accurate estimate of the future. If the margin is a large one, then it isenough to assume that future earnings will not fall far below those of the past in order for an investor tofeel sufficiently protected against the vicissitudes of time.

The margin of safety for bonds may be calculated, alternatively, by comparing the total val(e of theenterprise2with the amount of debt. &itto for preferred stock issue' If the business owes /10 millionand is fairly worth /0 million, there is room for a shrinkage of twothirds in value)at least theoretically)before the bondholders will suffer loss. The amount of this e!tra value, or cushion, above the debtmay be appro!imated by using the average market price of the unior stock issues over a period of years.2ince average stock prices are generally related to average earning power, the margin of enterprisevalue over debt and the margin of earnings over charges will in most cases yield similar results.

2o much for the marginofsafety concept as applied to fi!edvalue investments. Can it be carried overinto the field of common stocks3 4es, but with some necessary modifications.

There are instances where a common stock may be considered sound because it enoys a margin of safetyas large as that of a good bond. This will occur, for e!ample, when a company has outstanding onlycommon stock that under depression conditions is selling for less than the amount of bonds that couldsafely be issued against it property and earning power. That was the position of a host of stronglyfinanced industrial companies at the low price levels of 156. In such instances the investor can obtainthe margin of safety associated with a bond,plusall the chances of larger income and principal

8 7uffett has been (uoted as saying these three words &8argin of 2afety' are the most important concept in investing. 4our mindset is important.The investor allows for being wrong* for having a margin of error built into his9her process. on:t drive a 5,000 pound truck over a bridge built tohold 10,000 pounds, drive a ;,000 pound truck.

+


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appreciation inherent in a common stock. &The only thing he lacks is the legal power to insist on dividendpayments or else)but this is a small drawback as compared with his advantages.' Common stocksbought under such circumstances will supply an ideal, through infre(uent, combination of safety andprofit opportunity. #s a (uite recent e!ample of this condition, let us mention once moreNational PrestoIndustries Stock, which sold of a total enterprise value of /== million in 15>6. ?ith its /1@ million ofrecent earnings before ta!es the company could easily have supported this amount of bonds.

In the ordinary common stock, brought for investment under normal conditions, the margin of safety liesin an e!pected earning power considerably above the going rate for bonds. In former editions weelucidated these points with the following figuresA

#ssume in a typical case that the earning power is 5B on the price and that the bond rate is =B* then the stock buyer will have anaverage annual margin of ;B accruing in his favor. 2ome of the e!cess is paid to him in the dividend rate* even though spent byhim, it enters into his overall investment result. The undistributed balance is reinvested in the business for his account.

In many cases s(ch reinveste) earnings fail to a)) commens(rately to the earning po*er an) val(e of his stoc+,&That iswhy the market has a stubborn habit of valuing earnings disbursed in dividends more generously than the portion retained in the

business.' 7ut, if the picture is viewed as a whole, there is a reasonably close connection between the growth of corporatesurpluses through reinvested earnings and the growth of corporate values.

Dver a tenyear period the typical e!cess of stock earning power over bond interest may aggregate =;0B of the price paid. Thisfigure is sufficient to provide a very real margin of safety)which, under favorable conditions, will prevent or minimi$e a loss. Ifs(ch a margin is present in each of a )iversifie) list of t*enty or more stoc+s- the probability of a favorable res(lt (n)er

fairly normal con)itions becomes very large,That is why the policy of investing in representative common stocks does notre(uire high (ualities of insight and foresight to work out successfully. If the purchases are made at the average level of themarket over a span of years, the prices paid should carry with them assurance of an ade(uate margin of safety. The danger toinvestors lies in concentrating their purchase in the upper levels of the market, or in buying nonrepresentative common stocksthat carry more than average risk of diminished earning power.

#s we see it, the whole problem of commonstock investment under 15>6 conditions lies in the fact thatin a typical case the earning power is now much less than 5B on the price paid.="et us assume that byconcentrating somewhat on the lowmultiplier issues among the large companies a defensive investormay now ac(uire e(uities at 16 times recent earnings)i.e., with an earnings return of E.B on cost. -e

may obtain a dividend yield of about =B, and he will have .,// of his cost reinveste) in the b(sinessfor his acco(nt,Dn this basis, the e!cess of stock earning power over bond interest over a tenyear basiswould still be too small to constitute an ade(uate margin of safety. %or that reason we felt that there arereal risks now even in a diversified list of sound common stocks. The risks may be fully offset by theprofit possibilities of the list* and indeed the investor may have no choice but to incur them)for

H6arning power is


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otherwise he may run an even greater risk of holding only fi!ed claims payable in steadily depreciatingdollars. +onetheless the investor would do well to recogni$e, and to accept as philosophically as he can,that the old package of good profit possibilities combined with small ultimate risk is no longer availableto him.

-owever, the risk of paying too high a price for good (uality stocks)while a real one)is not the chief

ha$ard confronting the average buyer of securities. #bservation over many years has ta(ght (s thatthe chief losses to investors come from the p(rchase of lo* 1(ality sec(rities at time of favorable

b(siness con)itions,The purchasers view the current good earnings as e(uivalent to Garning Fowerand assume that prosperity is synonymous with safety. It is in those years that bonds and preferred stocksof inferior grade can be sold to the public at a price around par, because they carry a little higher incomereturn or a deceptively attractive conversion privilege. It is then also, that common stocks of obscurecompanies can be floated at prices far above the tangible investment, on the strength of two or three yearsof e!cellent growth. (Graham speaks of the growth illusion and the dangers of paying a price for afranchisepaying over asset or replacement valuebecause investors confuse the continuation of high

earnings during rosy economic times with the average earnings power of the company !or e"ample#

paying peak earnings for a cyclical company is usually a disaster$

These securities do not offer an ade(uate margin of safety in any admissible sense of the term. Coverageof interest charges and preferred dividends must be tested over a number of years, including preferably aperiod of subnormal business such as in 15>0>1. The same is ordinarily true of commonstock earningsif they are to (ualify as indicators of earning power. Thus it follows that most of the fairweatherinvestments, ac(uired at fairweather prices, are destined to suffer disturbing price declines when thehori$on clouds overand often sooner than that. +or can the investor count with confidence on an eventualrecoveryalthough this does come about in some proportion of the cases)for he has never had a realsafety margin to tide him through adversity.

The philosophy of investment in growth stocks parallels in part and in part contravenes the marginofsafety principle. The gro*th stoc+ b(yerrelies on an e!pected earning power that is greater than theaverage shown in the past. Thus he may be said to substitute these e!pected earnings for the past record in

calculating carefully estimated future earnings should be a less reliable guide than the bare record of thepast* in fact, security analysis is coming more and more to prefer a competently e!ecuted evaluation ofthe future. Thus the growthstock approach may supply as dependable a margin of safety as is found inthe ordinary investment provided the calculation of the future is conservatively made, and provided itshows a satisfactory margin in relation to the price paid. (%his concept is critical for growth investors$

The danger in a growthstock program lies precisely here. %or such favored issues the market has atendency to set prices that will not be ade(uately protected by a conservative proection of estimates,when they differ from past performance, must err at least slightly on the side of understatement. Themargin of safety is always dependent on the price paid. It will be large at one price, small at some higherprice, none!istent at some still higher price. If, as we suggest, the average market level of most growthstocks is too high to provide an ade(uate margin of safety for the buyer, then a simple techni(ue of

diversified buying in this field may not work out satisfactorily. # special degree of foresight and udgmentwill be needed, in order that wise individual selections may overcome the ha$ards inherent in thecustomary market level of such issues as a whole.

The margin of safety idea becomes much more evident when we apply it to the field of undervalued orbargain securities. ?e have here, by definition, a favorable difference between price on the one hand andindicated or appraised value on the other. That difference is the safety margin. It is available for absorbingthe effect of miscalculations or worse than average luck. They buyer of bargain issues places particular

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emphasis on the ability of the investment to withstand adverse developments. %or in most such cases hehas no real enthusiasm about the company:s prospects. True, if the prospects are definitely bad theinvestor will prefer to avoid the security no matter how low the price. 7ut the field of undervalued issuesis drawn from the many concerns)perhaps a maority of the total)for which the future appears neitherdistinctly promising nor distinctly unpromising. If these are bought on a bargain basis, even a moderatedecline in the earning power need not prevent the investment from showing satisfactory results. The

margin of safety will then have served its proper purpose.

&%#!' #$ 3I4%!SI$IC&I#"

There is a close logical connection between the concept of safety margin and the principle ofdiversification. Dne is correlative with the other. Gven with a margin in the investor:s favor, an individualsecurity may work out badly. %or the margin guarantees only that he has a better chance for profit than forloss)not that loss is impossible. 7ut as the number of such commitments is increased the more certaindoes it become that the aggregate of the profits will e!ceed the aggregate of the losses. That is the simplebasis of the insuranceunderwriting business.

iversification is an established tenet of conservativeinvestment. 7y accepting it so universally,investors are really demonstrating their acceptance of the marginofsafety principle, to whichdiversification is the companion. This point may be made more colorful by a reference to the arithmetic ofroulette. If a man bets /1 on a single number, he is paid /; profit when he wins)but the chances are >to 1 that he will lose. -e has a negativemargin of safety. In his case diversification is foolish. The morenumbers he bets on, the smaller his chance of ending with a profit. If he regularly bets /1 on everynumber &including 0 and 00', he is certain to lose /6 on each turn of the wheel. 7ut suppose the winnerreceived /5 profit instead of /;. Then he would have a small but important margin of safety. Therefore,the more numbers he wagers on, the better his chance of gain. #nd he could be certain of winning /6 onevery spin by simply betting /1 each on all the numbers. &Incidentally, the two e!amples given actuallydescribe the respective positions of the player and proprietor of a wheel with a 0 and 00.' ;

C!I&%!I#" #$ I"4%S&M%"& 4%!S5S S6%C57&I#"

2ince there is no single definition of investment in general acceptance, authorities have the right to defineit pretty much as they please. 8any of them deny that there is any useful or dependable differencebetween the concepts of investment and of speculation. ?e think this skepticism is unnecessary andharmful. It is inurious because it lends encouragement to the innate leaning of many people toward thee!citement and ha$ards of stockmarket speculation. ?e suggest that the margin of safety concept may beused to advantage as the touchstone to distinguish an investment operation from a speculative one.

Frobably most speculators believe they have the odds in their favor when they take their chances, andtherefore they may lay claim to a safety margin in their proceedings. Gach one has the feeling that thetime is propitious for his purchase, or that his skill is superior to the crowd:s, or that his adviser or system

& In #merican roulette, most wheels include a 0 and 00 along with numbers 1 through @, for a total of E slots. The casino offers a ma!imumpayout of ; to 1. ?hat if you /1 on every number3 2ince only one slot can be the one into which the ball drops, you would win /6; on that slot,but lose /1 on each of your other > slots, for a net loss of /6. That /6 difference &or a ;.6@B spread on your total /E bet' is the casino:s houseadvantage, ensuring that, on average, roulette players will always lose more than they win. ust as it is in the roulette player:s interest to bet asseldom as possible, it is in the casino:s interest to keep the roulette wheel spinning. "ikewise, the intelligent investor should seek to ma!imi$e thenumber of holdings that offer a better chance for profit than for loss. %or most investors, diversification is the simplest and cheapest way towiden your margin of safety.

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is trustworthy. 7ut such claims are unconvincing. They rest on subective udgment, unsupported by anybody of favorable evidence or any conclusive line of reasoning. ?e greatly doubt whether the man whostakes money on his view that the market is heading up or down can ever be said to be protected by amargin of safety in any useful sense of the phrase.

7y contrast, the investor:s concept of the margin of safety)as developed earlier in this chapter)rests

upon simple and definite arithmetical reasoning from statistical data. ?e believe, also that it is wellsupported by practical investment e!perience. There is no guarantee that this fundamental (uantitativeapproach will continue to show favorable results under the unknown conditions of the future. 7ut,e(ually, there is no valid reason for pessimism on this score.

Thus, in sum, we say that to have a true investment there must be present a true margin of safety. #nd atrue margin of safety is one that can be demonstrated by figures, by persuasive reasoning, and byreference to a body of actual e!perience.

%8&%"SI#" #$ &% C#"C%6& #$ I"4%S&M%"&

To complete our discussion of the margin of safety principle we must now make a further distinctionbetween conventional and unconventional investments. Conventional investments are appropriate for thetypical portfolio. Jnder this heading have always come Jnited 2tates government issues and high grade,dividend paying common stocks. ?e have added state and municipal bonds for those who will benefitsufficiently by their ta!e!empt features. #lso included are first(uality corporate bonds when, as now,they can be bought to yield sufficiently more than Jnited 2tates saving bonds.

Jnconventional investments are those that are suitable only for the enterprising investor. They cover awide range. The broadest category is that of undervalued common stocks of secondary companies, whichwe recommend for purchase when they can be bought at two thirds or less of their indicated value.7esides these, there is often a wide choice of medium grade corporate bonds and preferred stocks whenthey are selling at such depressed prices as to be obtainable also at a considerable discount from theirapparent value. In these cases the average investor would be inclined to call the securities speculative,because in his mind their lack of a first(uality rating is synonymous with a lack of investment merit.

It is our argument that a sufficiently low price can turn a security of mediocre (uality into a soundinvestment opportunity provided that the buyer is informed and e!perienced and that he create asubstantial margin of safety, the security thereby meets out criterion of investment. Dur favoritesupporting illustration is taken from the field of real estate bonds. In the 1560s, billions of dollars: worthof these issues were sold past par and widely recommended as sound investments. # large proportion hadso little margin of value over debt as to be in fact highly speculative in character. In the depression of the150:s an enormous (uantity of these bonds defaulted their interest, and their price collapsed)in somecase below 10 cents on the dollar. #t that stage the same advisors who had recommended them at par assafe investments were reecting them as paper of the most speculative and unattractive type. 7ut as a

matter of fact the price depreciation of about 50B made many of these securities e!ceedingly attractiveand reasonable safe)for the stated values behind them were four or five times the market (uotation


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Go years of the late /012s and early /032s %hose high 4uality companies like *von# I56# P7G became

one decision stocks to be held forever even at absurdly high prices %his concept was crushed during the

bear market of /0389/03: when stock prices of those companies declined ;2< to =2


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embarking on a business venture of his own, which must be run in accordance with accepted businessprinciples if it is to have a chance of success.

The first and most obvious of these principles is, no* *hat yo( are )oing;+no* yo(r b(siness,(circle of competence'. %or the investor this meansA o not try to make business profits out of securities)that is, returns in e!cess of normal interest and dividend income)unless you know as much about

security values as you would need to know about the value of merchandise that you proposed tomanufacture or deal in.

# second business principleA o not let anyone else run your business, unless &1' you can supervise hisperformance with ade(uate care and comprehension or &6' you have unusually strong reasons for placingimplicit confidence in his integrity and ability. %or the investor this rule should determine the conditionsunder which he will permit someone else to decide what is done with his money.

# third business principleA o not enter upon an operation)that is, manufacturing or trading in an item)unless a reliable calculation shows that it has a fair chance to yield a reasonable profit. In particular,keep away from ventures in which you have little to gain and much to lose. %or the enterprising investorthis means that his operations for profit should be based not on optimism but on arithmetic. %or everyinvestor it means that when he limits his return to a small figureas formerly, at least, in a conventionalbond or preferred stock)he must demand convincing evidence that he is not risking a substantial part ofhis principal.

# fourth business rule is more positiveA -ave the courage of your knowledge and e!perience. If youhave formed a conclusion from the facts and if you know your udgment is sound, act on it)even thoughothers may hesitate or differ.


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"osing some money is an inevitable part of investing, and there is nothing you can do to prevent it. 7ut,to be an intelligent investor, you must take responsibility for ensuring that you never lose most or all ofyour money. The -indu


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Benjamin Graham?s vie* of Margin of Safety@

3ec A- 200.

7enamin


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Tese notes "ill e;amine prices and Mr. Mar#et.

?er!sire Fata"ay 8RQI: Mar!etable Securities 1 Permanent Foldings

$ene%er Carlie (Munger) and buy common stoc!s for Ber#shire+sinsurance companies "e approac te transaction as if "e "ere bu*ing intoa priate business. $e loo! at te economic prospects of te business, tepeople in carge of running it, and te price "e must pay. $e do not a%e inmind any time or price for sale. ndeed, "e are "illing to old a stoc!inde2nitely so long as "e e;pect te business to increase in intrinsic %alue at

a satisfactory rate. $en in%esting, "e %ie" oursel%es as business analysts 1not as mar!et analysts, not as macroeconomic analysts, and not e%en assecurity analysts.

ur approac ma!es an actie trading market useful, since itperiodically presents us "it mout1"atering opportunities. ?ut by no meansis it essential: a prolonged suspension of trading in te securities "e old"ould not boter us any more tan does te lac! of daily uotations on)orl" Boo# orechheimer. 6%entually, our economic fate "ill be determined

by te economic fate of te business "e o"n, "eter our o"nersip ispartial or total.

4en ?raham, m* friend and teacher, long ago described themental attitude to(ard market uctuations that beliee to be mostconducie to inestment success.AFe said tat you sould imaginemar!et uotations as coming from a remar!ably accommodating fello"named Mr. Mar#et"o is your partner in a pri%ate business. $itout fail, Mr.Mar#etappears daily and names a price at "ic e "ill eiter buy your

interest or sell you is.

QSee 5raam*s "ritings on Mr. Mar#et0 on pages I and Q.

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6%en toug te business tat te t"o of you o"n may a%e economiccaracteristics tat are stable, Mr. Mar#etYs uotations "ill be anyting but.or, sad to say, te poor fello" as incurable emotional problems. Bt timese feels euporic and can see only te fa%orable factors a


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behaior from the super-contagious emotions that s(irl about themarketplace.n my o"n e


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$en "as a boy spent some time in a ranc in Montana. n Saturday nigts"e "ould dri%e into to"n to a co>y ta%ern "ere tere "as a perpetual po!er game.

Tis arrangement pro%ided te ouse "it t"o ad%antages from "ic it pro2tedmigtily. irst, it sold "is!ey to te players, and second, it furnised a permanent

dealerJa girl, as it appenedJ"o didn*t drin! erself. Te co"boys* mission "asto a%e a good time after a toug "ee!. Fers "as to ma!e money for er employer.Se !ne" te odds, -she (as rational/and almost al"ays pulled furter and furteraead as te nigt "ore on and te co"boys, lubricated by boo>e, became e%er

jollier and more prone to e;citing but illogical bets (emotional in%estors, teCo"boys "ere Mr. Mar#et, Ben0raham*s term for te emotional s"ings in temar!et).

n all games te di


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tis %aluable ser%ice free of carge. Sometimes Mr. Mar#etsets prices at le%els"ere you "ould neiter "ant to buy or to sell. reuently, o"e%er, e becomesirrational. Sometime e is optimistic and "ill pay for more tan securities are "ort.ter times e is pessimistic, o


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corresponding increase in underlying %alue. -i!e"ise, a price fall in and of itselfdoes not necessarily re3ect ad%erse business de%elopments or %alue deteriorationR.

t is itall* important for inestors to distinguish stock priceuctuations from underl*ing business realit*.f te general tendency is forbuying to beget more buying and selling to precipitate more selling, in%estors must2gt te tendency to capitulate to mar!et forces. #ou cannot ignore te mar!etJignoring a source of in%estment opportunities "ould ob%iously be a mista!eJbut*ou must think for *ourselfand not allo" te mar!et to direct you. /alue inrelation to price, not price alone, must determine your in%estment decisions. f youloo! to Mr. Mar#etas a creator of in%estment opportunities ("ere price departsfrom underlying %alue), you a%e te ma!ings of a %alue in%estor. f you insist onloo!ing to Mr. Mar#etfor in%estment guidance, o"e%er, you are probably bestad%ised to ire someone else to manage your money.

Securit* prices moe up and do(n for t(o basic reasons: to reectbusiness realit* or inestor perceptions of that realit*2 or to reect short-term ariations in suppl* and demand. 7eality can cange in a number of"ays, some company1speci2c, oters macroeconomic in nature. f %oca4%ola3sbusiness e;pands or prospects impro%e and te stoc! price increases proportionally,te rise may simply re3ect an increase in business %alue. fAetna3ssare priceplunges "en a urricane causes billions of dollars in catastropic losses, a declinein total mar!et %alue appro;imately eual to te estimated losses may beappropriate. $en te sares of un"American %ompanies, Inc.surge as a result ofte une;pected announcement of te sale of its major subsidiary, ireman3s un"

Insurance%ompany, at a %ery ig price, te price increase re3ects te sudden andnearly complete reali>ation of underlying %alue. n a macroeconomic le%el a broad1based decline in interest rates, a drop in corporate ta; rates, or a rise in tee;pected rate of economic gro"t could eac precipitate a general increase insecurity prices.

Security prices sometimes 3uctuate not based on any apparent canges inreality, but on canges in in%estor perception. Te sares of many biotecnologycompanies doubled and tripled in te 2rst monts of 8RR8, for e;ample despite alac! of cange in company or industry fundamentals tat could possibly a%e

e;plained tat magnitude of increase. Te only e;planation for te price rise "astat in%estors "ere suddenly "illing to pay muc more tan before to buy te sameting.

R

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gain incites greed in in%estors. 5reed leads many in%estors to see! sortcuts toin%estment success. 7ater tan allo"ing returns to compound o%er time, teyattempt to turn uic! pro2ts by acting on ot tips. Tey do not stop to consider o"te tipster could possibly be in possession of %aluable information tat is notillegally obtained or "y, if it is so %aluable, it is being made a%ailable to tem.885reed also manifests itself as undue optimism or, more subtly, as complacency in

te face of bad ne"s. inally greed can cause in%estors to sift teir focus a"ayfrom te acie%ement of long1term in%estment goals in fa%or of sort1termspeculation.

Summary of a ?oom=?ust Cycle

Fig le%els of greed sometimes cause ne"1era tin!ing to be introduced by

mar!et participants to justify buying or olding o%er%alued securities. 7easons aregi%en as to "y tis time is died for "at it is, re%erses course,and turns into a selling panic. 5reed gi%es "ay to fear, and in%estor losses can beenormous.

Aun! ?ond Mania

Bs discuss later in detail, jun! bonds "ere de2nitely suc a mania. Prior to te8RQ's te entire jun! bond mar!et consisted of only a fe" billion dollars of fallen0angels.0 Bltoug ne"ly issued jun! bonds "ere a 8RQ's in%ention and "ere tusuntested o%er a full economic cycle, tey became "idely accepted as a 2nancialinno%ation of great importance, "it total issuance e;ceeding +'' billion. ?uyersgreedily departed from istorical standards of business %aluation andcredit"ortiness. 6%en after te bubble burst, many proponents stubbornly clung tote %alidity of te concept.

88Bn intelligent in%estor "ill al"ays as! "o is on te oter side of te trade from im or er and "y do a%etis opportunity@ $o as te edge@ Fumility "ill elp you.



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Te 7ele%ance of Temporary Price luctuations

n addition to te probability of permanent loss attaced to an in%estment, tereis also te possibility of interim price 3uctuations tat are unrelated to underlying%alue. (?eta fails to distinguis bet"een te t"o.) Many in%estors consider price3uctuations to be a signi2cant ris!: if te price goes do"n, te in%estment is seenas ris!y regardless of te fundamentals. ?ut are temporary price 3uctuations reallya ris!@ 4ot in te "ay tat permanent %alue impairments are and ten only forcertain in%estors in speci2c situations.

t is, of course, not al"ays easy for in%estors to distinguis temporary price%olatility, related to te sort1term, forces of supply and demand, from pricemo%ements related to business fundamentals. Te reality may only become

apparent after te fact, "ile in%estors sould ob%iously try to a%oid o%erpaying forin%estments or buying into businesses tat subseuently decline in %alue due todeteriorating results, it is not possible to a%oid random sort1term mar!et %olatility.ndeed, in%estors sould e;pect prices to 3uctuate and sould not in%est insecurities if tey cannot tolerate some %olatility.

f you are buying sound %alue at a discount, do sort1term price 3uctuationsmatter@ n te long1run tey do not matter mucL %alue "ill ultimately be re3ectedin te price of a security. ndeed, ironically, te long1term in%estment implication ofprice 3uctuations is in te opposite direction from te near1term mar!et impact. or

e;ample, sort1term price declines actually enance te returns of long1termin%estors.8+Tere are, o"e%er, se%eral e%entualities in "ic near1term price3uctuations do matter to in%estors. Security olders "o need to sell in a urry areat te mercy of mar!et prices. Te tric! of successful in%estors is to sell "en tey

8+Consider te e;ample of a 2%e1year 8' percent bond paying interest semiannually "ic is purcased at par(8''). Bssuming tat interest rates remain uncanged o%er te life of te bond, interest coupons can also bein%ested at 8' percent, resulting in an annual rate of return of 8' percent for tat bond. f immediately after tebond is purcased, interest rates decline to & percent, te bond "ill initially rise to 8+8.QQ from 8''. Te bondrises in price to re3ect te present %alue of 8' percent interest coupons discounted at a & percent interest rate o%er2%e years. Te bond could be sold for a pro2t of nearly ++ percent. Fo"e%er, if te in%estor decides to old tebond to maturity, te annuali>ed return "ill be only R.8' percent. Tis is less tan in te 3at interest case because

te interest coupons are rein%ested at 2%e percent, not 8' percent. 9espite te potential sort1term pro2t from adecline in interest rates, te return to te in%estor "o olds on to te bonds is actually reduced.Similarly, if interest rates rise to 8& percent immediately after purcase, te in%estor is faced "it a mar!et declinefrom par to Q+.Q, a 8I percent loss. Te total return, if e olds te bond for 2%e years, is increased, o"e%er, to8'.RR percent as coupons are rein%ested at 8&D. Tis e;ample demonstrates o" te sort1term and long1termperspecti%es on an in%estment can di%erge. n a rising mar!et, many people feel "ealty due to unreali>ed capitalgains, but tey are li!ely to be "orse o< o%er te long run tan if security prices ad remained lo"er and tereturns to incremental in%estment iger.

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"ant to, not "en tey a%e to. n%estors "o may need to sell sould not o"nmar!etable securities oter tan E.S. treasury bills.

4ear1term security prices also matter to in%estors in a troubled company. f abusiness must raise additional capital in te near term to sur%i%e, in%estors in itssecurities may a%e teir fate determined, at least in part, by te pre%ailing mar!etprice of te company*s stoc! and bonds.

Te tird reason long1term oriented in%estors are interested in sort1term price3uctuation is tat Mr. Mar#etcan create %ery attracti%e opportunities to buy andsell. f you old cas, you are able to ta!e ad%antage of suc opportunities. f youare fully in%ested "en te mar!et declines, your portfolio "ill li!ely drop in %alue,depri%ing you of te bene2ts arising from te opportunity to buy in at lo"er le%els.

Tis creates an opportunity cost, te necessity to forego future opportunities tatarise. f "at you old is illiuid or unmar!etable, te opportunity cost increasesfurterL te illiuidity precludes your s"itcing to better bargains.

11

'he ntelligent nestor b* 4enBamin ?raham, Re. d. 3ages DEF-DE6

-et us close tis section "it someting in te nature of a parable. magine tatin some pri%ate business you o"n a small sare tat cost you 8,'''. ne of yourpartners, named Mr. Mar#et, is %ery obliging indeed. 6%ery day e tells you "at etin!s your interest is "ort and furtermore o


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Te true in%estor is in tat %ery position "en e o"ns a listed common stoc!.Fe can ta!e ad%antage of te daily mar!et price or lea%e it alone, as dictated by iso"n judgment and inclination. Fe must ta!e cogni>ance of important pricemo%ements, for oter"ise is judgment "ill a%e noting to "or! on. Concei%ablytey may gi%e im a "arning signal "ic e "ill do "ell to eedJtis in plain6nglis means tat e is to sell is sares !ecausete price as gone do"n,

foreboding "orse tings to come. n our %ie" suc signals are misleading at least asoften as tey are elpful. ?asically, price 3uctuations a%e only one signi2cantmeaning for te true in%estor. Tey pro%ide im "it an opportunity to buy "isely"en prices fall sarply and to sell "isely "en tey ad%ance a great deal. Bt otertimes e "ill do better if e forgets about te stoc! mar!et and pays attention to isdi%idend returns and to te operating results of is companies.

Te most realistic distinction bet"een te in%estor and te speculator is found inteir attitude to"ard stoc!1mar!et mo%ements. Te speculator*s primary interestlies in anticipating and pro2ting from mar!et 3uctuations. Te in%estor*s primaryinterest lies in acuiring and olding suitable securities at suitable prices. Mar!etmo%ements are important to im in a practical sense, because tey alternatelycreate lo" price le%els at "ic e "ould be "ise to buy and ig price le%els at"ic e certainly sould refrain from buying and probably "ould be "ise to sell.

11

!ommentar* b* Gason H(eig on ?rahamIs Mr. Market

&he happiness of those (ho (ant to !e popular "epen"s on others5 the happinessof those (ho see# pleasure 6uctuates (ith moo"s outsi"e their control5 !ut thehappiness of the (ise gro(s out of their o(n free actsMarcus Aurelius

Most of te time, te mar!et is mostly accurate in pricing most stoc!s. Millions ofbuyers and sellers aggling o%er price do a remar!ably good job of %aluingcompaniesJon a%erage. ?ut sometimes, te price is not rigtL occasionally, it is%ery "rong indeed. Bnd at suc times, you need to understand 0raham3simage of

Mr. Mar#et, probably te most brilliant metapor e%er created for e;plaining o"stoc!s can become mispriced. Te manic1depressi%e Mr. Mar#etdoes not al"aysprice stoc!s te "ay an appraiser or a pri%ate buyer "ould %alue a business.nstead, "en stoc!s are going up, e appily pays more tan teir objecti%e %alueLand, "en tey are going do"n, e is desperate to dump tem for less tan teirtrue "ort.

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Te intelligent in%estor souldn*t ignore Mr. Mar#etentirely. nstead, you soulddo business "it imJbut only to te e;tent tat it ser%es your interests. Mr.Mar#et3sjob is to pro%ide you "it pricesL your job is to decide "eter it is to yourad%antage to act on tem. #ou do not a%e to trade "it im just because econstantly begs you to.

ne of 0raham3s most po"erful insigts is tis: 'he inestor (ho permitshimself to be stampeded or undul* (orried b* unBusti7ed market declinein his holdings is perersel* transforming his basic adantage into a basicdisadantage.ard in testoc! mar!et, by di%ersifying, and by rebalancing.

8H$en as!ed "at !eeps most indi%idual in%estors from succeeding, 5raam ad a concise ans"er: 'heprimar* cause of failure is that the* pa* too much attention to (hat the stock market is doingcurrentl*.ine, no. +, Marc 8RR8, page Q.

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Aust remember tat in%esting really isn*t about beating oters at teir game. t isabout controlling yourself at your o"n game.

11

$isadantages of )arket 8nal*sis as !ompared (ith Securit* 8nal*sis inSecurit* 8nal*sis, Dnddition, pages JEK-JE6.

$e return in conseuence to our earlier conclusion tat mar!et analysis is an art for"ic special talent is needed in order to pursue it successfully. Security analysis isalso an artL and it, too, "ill not yield satisfactory results unless te analyst asability as "ell as !no"ledge.

$e tin!, o"e%er, tat security analysis as se%eral ad%antages o%er mar!etanalysis, "ic are li!ely to ma!e te former a more successful 2eld of acti%ity fortose "it training and intelligence. n securit* anal*sis the prime stress islaid upon protection against unto(ard

eents. +e obtain this protection b* insisting upon margins of safet*, oralues (ell in ecess of the price paid.Te underlying idea is tat e%en if tesecurity turns out to be less attracti%e tan it appeared, te commitment migt stillpro%e a satisfactory one.

n mar!et analysis tere are no margins of safetyL you are eiter rigt or "rong,and, if you are "rong, you lose money. /ie"ing te t"o acti%ities as possible

professions, "e are inclined to dra" an analogous comparison bet"een te la" andte concert stage. B talented la"yer sould be able to ma!e a respectable li%ingL atalented, i.e., a merely talented,0 musician faces eartbrea!ing obstacles to asuccessful concert career. Tus, as "e see it, a torougly competent securitiesanalyst sould be able to obtain satisfactory results from is "or!, "ereaspermanent success as a mar!et analyst reuires unusual ualitiesJor unusual luc!.

Te cardinal rule of te mar!et analyst tat losses sould be cut sort and pro2tssafeguarded (by selling "en a decline commences) leads in te direction of acti%etrading. Tis means in turn tat te cost of buying and selling becomes a ea%ilyad%erse factor in aggregate results.

perations based on security analysis are ordinarily of te in%estment type and donot in%ol%e acti%e trading.

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B tird disad%antage of mar!et analysis is tat it in%ol%es essentially a battle of"its. Pro2ts made by trading in te mar!et are for te most part reali>ed at tee;pense of oters "o are trying to do te same ting. Te trader necessarilyfa%ors te more acti%e issues, and te price

canges in tese are te resultant of te acti%ities of numerous operators of is o"n

type. Te mar!et analyst can be opeful of success only upon te assumption tate "ill be more cle%er or peraps luc!ier tan is competitors.

Te "or! of te securities analyst, on te oter and, is in no similar sensecompetiti%e "it tat of is fello" analysts. n te typical case te issue tat eelects to buy is not sold by someone "o as made an eually painsta!ing analysisof its %alue. $e must empasi>e te point

tat te security analyst e;amines a far larger list of securities tan does te

mar!et analyst. ut of tis large list, e selects te e7ceptional casesin "ic temar!et price falls far sort of re3ecting intrinsic %alue, eiter troug neglect orbecause of undue empasis laid upon unfa%orable factors tat are probablytemporary.

Mar!et analysis seems easier tan security analysis, and its re"ards may bereali>ed muc more uic!ly. or tese %ery reasons, it is li!ely to pro%e moredisappointing in te long run. 'here are no dependable (a*s of making mone*easil* and ;uickl*, either in +all Street or an*(here else.

3rophesies 4ased on #ear-term 3rospects

B good part of te analysis and ad%ice supplied in te 2nancial district rests uponte near1term

business prospects of te company considered. t is assumed tat, if te outloo!fa%ors increased earnings, te issue sould be bougt in te e;pectation of a igerprice "en te larger pro2ts are actually reported. n tis reasoning, securityanalysis and mar!et analysis are made to coincide. Te mar!et prospect is tougtto be identical "it te business prospect. ?ut to our mind te teory of buyingstoc!s cie3y upon te basis of teir immediate outloo! ma!es te selection ofspeculati%e securities entirely too simple a matter. ts (eakness lies in the factthat the current market price alread* takes into account the consensus ofopinion as to future prospects.Bnd in many cases te prospects "ill a%e beengi%en more tan teir just need of recognition. $en a stoc! is recommended forte reason tat ne;t year*s earnings are e;pected to so" impro%ement, a t"ofold

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a>ard is in%ol%ed. irst, te forecast of ne;t year*s results may pro%e incorrectLsecond, e%en if correct, it may a%e been discounted or e%en o%er discounted in tecurrent price.

f mar!ets generally re3ected only tis year*s earnings, ten a good estimate ofne;t year*s results "ould be of inestimable %alue. ?ut te premise is not correct.ur table on page I+R so"s on te one and te annual earnings per sare ofEnited States Steel Corporation common and on te oter and te price range oftat issue for te years 8R'+U8RHR. 6;cluding

te 8R+QU8RHH period (in "ic business canges "ere so e;treme as necessarily toinduce corresponding canges in stoc! prices)L it is diNcult to establis any de2nitecorrelation bet"een 3uctuations in earnings and 3uctuations in mar!et uotations.

n te Bppendi;, 4ote I', "e reproduce signi2cant parts of te analysis andrecommendation concerning t"o common stoc!s made by an important statisticaland ad%isory ser%ice in te latter part of 8RHH. Te recommendations are seen to bebased largely upon te apparent outloo! for 8RH. Tere is no indication of anyendea%or to ascertain te fair %alue of te business and to compare tis %alue "itte current price. B toroug1going statistical analysis "ould point to te conclusiontat te issue of "ic te sale is ad%ised "as selling belo" its intrinsic %alue, justbecause of te unfa%orable immediate prospects, and tat te opposite "as true ofte common stoc! recommended as "ort olding because of its satisfactoryoutloo!.

$e are s!eptical of te ability of te analyst to forecast "it a fair degree of successte mar!et bea%ior of indi%idual issues o%er te near1term futureJ"eter ebase is predictions upon te tecnical position of te mar!et or upon te generaloutloo! for business or upon te speci2c outloo! for te indi%idual companies. Moresatisfactory results are to be obtained, in our opinion, by con2ning te positi%econclusions of te analyst to te follo"ing 2elds of endea%or:

8. Te selection of standard senior issues tat meet e;acting tests of safety.

+. Te disco%ery of senior issues tat merit an in%estment rating but tat also a%eopportunities of an

appreciable enancement in %alue.

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automatically as some in3uence on you.0 Conductors a%e li!e"ise learned tattey can e%aluate a classical musician more objecti%ely if te audition is playedfrom beind a screen, "ere no preconceptions about o" te musician loo!s cana

chapter 20_margin of safety concept and more notes

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