Margin of Safety

b. That we will attempt to bring risk of permanent capital loss (not short-term quotational loss) to an absolute minimum by obtaining a wide margin of safety in each commitment and a diversity of commitments; and Sometimes these work out very fast; many times they take years. It is difficult at the time of purchase to know any compelling reason why they should appreciate in price. However, because of this lack of glamour or anything pending which might create immediate favorable market action, they are available at very cheap prices. A lot of value can be obtained for the price paid. This substantial excess of value creates a comfortable margin of safety in each transaction. Combining this individual margin of safety with a diversity of commitments creates a most attractive package of safety and appreciation potential. We do not go into these generals with the idea of getting the last nickel, but are usually quite content selling out at some intermediate level between our purchase price and what we regard as fair value to a private owner.

The pitfalls of this business mandate an operating principle that too often is ignored: Though certain long-tail lines may prove profitable at combined ratios of 110 or 115, insurers will invariably find it unprofitable to price using those ratios as targets. Instead, prices must provide a healthy margin of safety against the societal trends that are forever springing expensive surprises on the insurance industry. Setting a target of 100 can itself result in heavy losses; aiming for 110—115 is business suicide. In the final chapter of The Intelligent Investor Ben Graham forcefully rejected the dagger thesis: “Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety.” Forty-two years after reading that, I still think those are the right three words. The failure of investors to heed this simple message caused them staggering losses as the 1990s began.

WARREN BUFFETT: We make our decisions in insurance and in buying businesses with a very pessimistic attitude toward the chances of that particular ill that Charlie described being even moderated. I mean, we think if — we would project out that the trend would accelerate, but that’s just our natural way of building in a margin of safety in decisions. Don’t worry about eating the See’s candy, or the Dairy Queen, or the Coke. You know, if you read the papers long — I use a lot of salt, and, you know, I was always being warned about that. And then, you know, few years ago they started saying, “You know, you can’t get enough salt” and all that. I don’t know what the answer is, but I feel terrific. (Laughter) CHARLIE MUNGER: Well, the production of electricity, of course, is an enormous business. And it’s not going away. And the thought that there might be something additional that we might do in that field is not at all inconceivable. It’s a very fundamental business. Now, you’re certainly right in that we have an unholy mess, in California, in terms of electricity. And again, it reflects, I would say, a fundamental flaw in the education system of the country, that is many smart people of all kinds, utility executives, governors, legislators, journalistic leaders, they have difficulty recognizing that the most important thing with a power system is to have a surplus of capacity. Is that a very difficult concept? (Laughter) You know, everybody understands that if you’re building a bridge, you don’t want a bridge that will handle exactly 20,000 pounds and no more. You want a bridge that’ll handle a lot more than the maximum likely load. And that margin of safety is enormously important in bridge building. Well, a power system is a similar thing.

AUDIENCE MEMBER: Hi. My name is Jeremy from San Diego. And, first of all, I want to thank you all for the tremendous impact that you’ve had on my career as a professional investor. My question is also about the newspaper industry that the gentleman earlier touched on. And for some of those same points that you brought up, some of the largest newspaper stocks seem to earn incredible return on invested capital as compared to a lot of the businesses in the S&P 500. My question is more specifically related to valuation. If either of you were looking at a newspaper stock today and watching them fall, as some people may categorize falling knives, what would you use to determine — or how would you determine a very comfortable margin of safety to protect yourself against the deteriorating aspects of the newspaper industry?

AUDIENCE MEMBER: Hello, my name is Jeff Colvette (PH) and I’m from Olathe, Kansas. I got started in investing in 1999, right before the big tech bubble, and unfortunately I learned buy and hold and don’t fret about market price fluctuations before I learned the importance of valuing a business and applying a margin of safety. So, as Charlie said, I got my feet wet with huge failure right away. And — AUDIENCE MEMBER: Thank you, I don’t feel so bad now. So that leads to my question. It seems like I’ve read all the Berkshire reports and all the reading I can do about you two, and I thank you for these wonderful meetings. But it seems like it boils down to some simple things, valuing a business and applying a margin of safety. So my question is, what do you recommend for an approach to getting better and better at valuing companies?

WARREN BUFFETT: And they were a lot smarter than we were. (Laughs) That’s what’s depressing. But we both have the same bend of mind whereby we think about worst cases all the time, and then we add on a big margin of safety, and we don’t want to go back to go. I mean, I enjoy tossing those papers in the other room, but I don’t want to do it for a living again. So we undoubtedly build in layers of safety that others might regard as foolish, but we’ve got 600,000 shareholders and we’ve got members of my family that have 80 or 90 percent of their net worth in the company. And I’m just not interested in explaining to them that we went broke because there was a onehundredth of 1 percent chance that we would go broke and there was a — the remaining probability was filled by the chance of doubling our money, and I decided that that was just a good gamble to take. We’re not going to do that. It doesn’t mean that much. CHARLIE MUNGER: Yes, absolutely, if that’s your test. Should you feel better about the margin of safety in Berkshire? Yes, it’s fine.