Margin of Safety and Options

3 Ways to Protect Your Investment Capital

The 1929 Stock Market Crash changed Benjamin Graham.

After having had his ass handed to him - not to mention all the money he lost for his clients - he basically said, "Never again."

As a result, he spent the rest of his investing career committed to two principles:

Intrinsic Value - Determining what businesses (and their bonds) were really worth
Margin of Safety - Never making an investment unless he could do so at a significant discount to intrinsic value

That aversion to risk was evident in how he came to define investing.

Intelligent investing, he said, was first and foremost about the management of risk. The management of returns was secondary.

So if Graham's premise is correct - that the investor's first priority should be to manage his or her risk and let the returns take care of themselves - the question naturally arises, how can the individual investor best protect his or her investments?

There are basically three ways to secure a Margin of Safety on your investment capital.

Margin of Safety #1 - Price

The first kind of Margin of Safety is the one Graham envisioned - Price.

Others may prefer the word value over price, but we're essentially talking about the same thing - the less you pay for an asset, especially in terms of its intrinsic value, the better off you're going to be.

That's because the bigger the discount, the more you're protected against a miscalculation on your part.

Part of the reason why Graham demanded a discount to intrinsic value was that he realized at some level, no matter how fundamentally and intellectual rigorous the analysis, intrinsic value contained subjective judgments.

At some level, intrinsic value is an estimate rather than a precise value.

And, of course, the discount also helped to protect against an unexpected deterioration in either the underlying business or the economy at large.

Finally, there's also the common sense angle - by definition, the more undervalued something is, the less downside risk there's going to be.

Margin of Safety #2 - Quality

But there's another margin of safety form that I believe is just as powerful as price, if not more powerful.

And that's the protection you gain from the quality of the investment itself.

In short, quality is a tremendous - and often overlooked - margin of safety.

These distinctions may be somewhat of an oversimplification, but if Graham is associated with risk control based on price and valuation, it's Warren Buffett's philosophy that epitomizes the quality principle.

Although Graham was a mentor to the young Buffett, Buffett himself would eventually modify his own value investing philosophy to embrace the idea that quality is at least as important as price.

When you own a high quality business, your primary protection is the operations of the underlying business itself.

It's true that you don't want to overpay for your investments, but the great luxury of investing in world class businesses is the comfort you get from knowing that your businesses will most likely outlive you.

(Maybe a better way of putting it is to just to say how great it feels to know that when you wake up each morning, your awesome business will still be there making lots of money for you.)

Case in point:

Imagine I gave you $10 million dollars but required that you invest it all in one of two companies for a minimum holding period of 10 years -

Coca-Cola (KO) or Sears Holdings (SHLD)

Now here's the kicker - if you choose KO, you have to pay a 20% premium to the current share price. But if you choose SHLD, you get to purchase at a 20% discount to the current share price.

That means, based on their current share prices, the choice would actually be between getting $8 million worth of KO stock or $12 million worth of SHLD stock.

That's a net difference of $4 million.

And yet . . .

I think you would be crazy to take me up on the SHLD offer.

A company like KO - with its powerhouse brand, massive distribution network, presence in 200 countries, and steadily increasing earnings and dividends - is a much better deal at a premium than a company hemorrhaging customers, revenues, and billions of dollars in losses every year at any price.

Or as I like to say, you're better off paying up for a golden goose than getting a steal on an albatross.

When you own a high quality, world class business that you have absolute confidence will thrive for decades to come, it's the underlying operations of the business itself that protects your capital from loss.

Do you really want a good deal on a bad business? Is there really a margin of safety in that approach?

Warren Buffett made this very point himself in a talk he had with MBA students back in 1998:

"Time is the friend of the wonderful business. It's the enemy of the lousy business. If you're in a lousy business for a long time you're going to get a lousy result, even if you buy it cheap. If you're in a wonderful business for a long time, even if you pay a little too much going in, you're going to get a wonderful result if you stay in a long time."

Margin of Safety #3 - Why Not Both (Price AND Quality)?

If you've spent any time at all on this website, then you know I don't believe in or accept the either-or mindset. I refuse to live in that kind of world.

I'm a firm believer in - and practitioner of - the both-and philosophy.

Instead of debating whether Choice A or Choice B is better, why not take the best qualities from each choice and combine them to make a new choice - Choice C?

(That's basically what I did when I combined the best attributes of value investing with the best attributes of option trading to design The Complete Leveraged Investing Program.)

And in this case - when you merge these two different margin of safety sources - you create a new, expanded margin of safety that's exponentially stronger (i.e. greater than the sum of its parts).

If you can manage both feats - buying high quality stocks at discounted prices - you'll have the best of both worlds - superior returns and below average risk.

For some, that's a pretty radical concept because of the number that the managed money industry has done on the investing public.

You've probably seen something like this graph before:

This is a pretty fair representation of what they like to circulate. It shows that if you want low risk, you have to accept low returns. And if you want high returns you have to be willing to tolerate a lot of risk.

That's completely bogus and is more about justifying the managed money industry's abysmal track record than educating people how investing really works.

Why have so many people bought into this nonsense?

High risk doesn't mean that you've got a chance to do better than everyone else. It means that it's just a matter of time before you lose everything.

I'll give you another (extreme) hypothetical scenario with two choices to illustrate:

Choice #1 - You play six rounds of Russian Roulette with yourself. If you survive, I pay you $1 million.

Choice #2 - I sell you a McDonald's franchise at a busy, low crime intersection for $1000.

So which choice has the lowest possible risk and the highest possible returns?

The less you pay to own - in whole or in part - a high quality business, the lower your risk and the higher your returns.

That's a cold, hard investing fact (actually, it's not cold or hard at all - it's warm and liberating).

The trick, of course, is how do you go about finding those kind of opportunities?

The traditional approach which has worked pretty well for a lot of old-time investors is to simple be patient and wait for the market to occasionally misprice the shares of a great business.

Then put to use all that cash you've been saving up while you waited.

Myself, I prefer to use strategic, low-risk option trades to make my own opportunities rather than wait around hoping Mr. Market will have a tantrum and give me a rare buying opportunity on his own.

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