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Margin of Safety

Comparative analysis, realistic analysis and accurate thinking are attributes of investing that are not often discussed. We are wired to oversimplify and be “lazy-brained,” and nowhere is the concept of the lazy way to riches more prevalent than on Wall Street -

Japan collapses – sell!

Japan recovers – buy!

Interest rates are going up – sell!

Bonds are going down – buy!

Japan

Japan’s tragedy is on a human scale. The “real” tragedy lies in the fact that people died and others are suffering. Japan’s economic costs are estimated to be between $100 to $300 billion dollars and is not inconsequential. However, Japan’s economy is more than $5 trillion. Putting this into perspective, $1 trillion is equal to $1,000 billion, so in the scope of Japan’s overall financial economy, this tragedy is not economically debilitating. With a global economy of around $61 trillion, it is irrational that a $100 or $300 billion event should move global markets. If Microsoft’s stock dropped by half, that would equal $100 billion. Sad for Microsoft shareholders, but really a non-event for the rest of the world. So why does the tragedy in Japan make investors run from the markets?

Bridges

On the island of Maui, Hawaii, there are 54 one-lane bridges on the two-way highway known as the “Road to Hana.” For a car or small truck, there is no risk of the bridge collapsing under its weight. However, somewhere between the Toyota 4WD pickup and a couple of cement trucks the risk of collapse exists. I would not feel comfortable riding in a cement truck across some of these bridges. If a bridge is rated at 25,000 pounds and I am driving in a 5,000-pound vehicle, I would feel fine. If I were at 24,990 pounds, I would not drive across. Personally, I would want a degree of safety sufficient to compensate me for the risk – perhaps a 10,000- or 15,000-pound margin of safety. Investing is the same way: You want to invest with a margin of safety.

A number of things add a margin of safety to investing:

1. Capital structure (lots of debt = high risk;lots of cash, little debt = low risk)
2. Industry (nuclear energy = high risk; wind, hydro, gas, solar (or combo) = low risk)
3. Company-specific risks (nuclear power station built on an earthquake fault line = high risk; real estate trust with properties leased long-term to the U.S. government = low(er) risk)
4. Management skill, ethics, integrity, culture (BP/Enron = significant management risks; tried-and-true management like Warren Buffett, Bill Gates, Steve Jobs = low(er) risk)
5. Price – i.e., paying the right price (all things being equal, paying 12x earnings is better than 20x) 6) Creating an optimized portfolio through the proper use of asset allocation, security diversification and other portfolio risk management tools
6. Utilizing proven, experienced, successful and educated managers

Management Is the Most Important Risk Management Tool

I am starting to collect stories, concepts and other pieces of data for a new investment book. I am enjoying the continued from page 1 excuse to be introspective about “how we manage” here at FIM Group. I can look impersonally and objectively at our results one security, one trade, one investment and one portfolio at a time and make the following conclusion: Resilient, skilled management is the secret sauce of a company’s long-term success. Poor management can lose money even if the price of their products is rising. With a lot of hard work and a little grace, great management can ride out the storms of business. If you took Bill Gates and Steve Jobs and plunked them into a poorly run business in a tough industry, I am confident that their skills would reward their investors, and the company would thrive. I am equally confident that a mediocre management team could screw up the finest of companies in short order.

How do you quantify fine management? It is both an art and a science. But it starts with virtue, commitment, integrity and authenticity and ends with skills, talent and vigor.