This article is authored by MOI Global instructor Fernando Pina, a Founding Partner of LIS Capital, based in Brazil.
The margin of safety concept, although being as old as the proper art of investing itself, was only formally introduced in the 1930s by Ben Graham and David Dodd, in their renowned book Security Analysis. To put it briefly, the authors argue that the secret of a sound investment is the very existence of the margin of safety, defined as the existence of a significant positive difference between the estimated value of an asset by a diligent investor and its market price. Thus, the investor would protect himself against the loss of capital in case of unfavorable future outcome and errors of estimation of the fair value.
The practice though, as often is the case, proves itself much more complex and intricate than theory suggests. The estimation of the fair value of a company is not a trivial task in the sense that it depends on the evaluation, often times subjective, of a series of quantitative and qualitative variables. The latter are sometimes difficult or even impossible to measure, but they are of no less importance in determining the fair value. For instance, governance issues cannot be worked in a spreadsheet, but represent a real problem in that they can lead to value erosion from minority shareholder’s hands, and therefore lead to permanent losses of capital. Margin of safety, therefore, is far from being an absolute concept; on the contrary, it must be seen from different angles. At LIS, we work with margin of safety concept in two basic different ways, depending on the quality traits of the company at hand.
As a rule, under normal market conditions, good companies, those with strong barriers to entry, well managed and oriented to shareholder value generation are usually overvalued by the market. Whereas companies we conveniently call “second-tier” — business models without obvious competitive advantages but low and controlled risks — may be priced much below the value that a private investor would be willing to pay or sometimes less than its asset replacement value.
We believe that good investment opportunities exist in both cases, but certainly each involves different types of risks and therefore require different approaches. Searching for margin of safety indistinctly may not be of much validity and worse still can lead to poor investment decisions. That is why we have developed different ways of assessing margin of safety, which we believe to be of enormous value since the opportunities the market presents us with vary greatly in nature and quality depending on the economic cycle and the general mood of the market.
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