Safety Margin
November 21st 2006 09:36
What is safety margin?
Safety margin is the allowance given to a new investment in order to get protection against a sudden price fall.
The creator of the idea of safety margin was Benjamin Graham, in the 1930s. In these days, following the crash of 1928, Graham realised he could find many companies that traded for a price below their net working capital (cash plus receivables and inventories).
He got into the practice of buying them, waiting for their price to increase, and then selling them.
Some companies, though, were problematic. Despite a long wait, their price just wouldn’t move up. What to do? After three years, Graham would just divest them.
Benjamin Graham found a now famous follower: Warren Buffet. While working for Graham, Buffett, still in his youth, would often argue with his employer on the basis that the product of a company, and not just the price to net working capital, should be considered.
Not for Graham, though. Graham believed in figures and stuck to his way.
Later on, Buffett went into practice for himself and started buying in Graham’s style. He made money but soon discovered that some companies such as Dempster, no matter what management did, were always just cheap and mediocre.
What he came to realise was that, despite the right figures, some business were, by their nature, just poor and never performing.
This contrasted with the realisation that some other business were brilliant, promising and always did well.
For Buffett, safety margin took a different shape: it was certainly a low price, but was also a great franchise.
The franchise’s ability to generate strong cash flows was the greatest insurance against the possibility of a sudden price drop.
Notice, though, that Buffett never bought anything with and high P/E.
This way, redefining safety margin, it is the combination of a low purchasing price with a strong franchise.
It’s worth saying, as a matter of caution, that a great business is not worth any price—indeed, the return you get depends directly on the price you pay.
Safety margin is the allowance given to a new investment in order to get protection against a sudden price fall.
The creator of the idea of safety margin was Benjamin Graham, in the 1930s. In these days, following the crash of 1928, Graham realised he could find many companies that traded for a price below their net working capital (cash plus receivables and inventories).
He got into the practice of buying them, waiting for their price to increase, and then selling them.
Some companies, though, were problematic. Despite a long wait, their price just wouldn’t move up. What to do? After three years, Graham would just divest them.
Benjamin Graham found a now famous follower: Warren Buffet. While working for Graham, Buffett, still in his youth, would often argue with his employer on the basis that the product of a company, and not just the price to net working capital, should be considered.
Not for Graham, though. Graham believed in figures and stuck to his way.
Later on, Buffett went into practice for himself and started buying in Graham’s style. He made money but soon discovered that some companies such as Dempster, no matter what management did, were always just cheap and mediocre.
What he came to realise was that, despite the right figures, some business were, by their nature, just poor and never performing.
This contrasted with the realisation that some other business were brilliant, promising and always did well.
For Buffett, safety margin took a different shape: it was certainly a low price, but was also a great franchise.
The franchise’s ability to generate strong cash flows was the greatest insurance against the possibility of a sudden price drop.
Notice, though, that Buffett never bought anything with and high P/E.
This way, redefining safety margin, it is the combination of a low purchasing price with a strong franchise.
It’s worth saying, as a matter of caution, that a great business is not worth any price—indeed, the return you get depends directly on the price you pay.
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