Margin of Safety
Black swans have three traits. First, it is an outlier: it lies outside the realm of regular expectations, because nothing in the past points to its possibility. Second, its impact is extreme. Third, in spite of being an outlier, human nature makes us concoct explanations for its occurrence after the fact to render it explainable and predictable.
How do you survive something you can’t comprehend, that impacts you heavily, and that you can only moralize about afterwards. One answer is found in a Benjamin Graham innovation, the margin of safety. Seth Klarman, in his rare book Margin of Safety, defines the margin of safety as being achieved when:
…securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable, and rapidly changing world. According to Graham, “The margin of safety is always dependent on the price paid. For any security, it will be large at one price, small at some higher price, nonexistent at some still higher price”.
Buffet described the margin of safety concept in terms of tolerances: “When you build a bridge, you insist that it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And the same principle works in investing.”
Graham initially found the margin of safety in buying stocks that were selling below their book value at that moment in time. Then, as the Depression years passed and screaming asset bargains started to dry up, there was more of a focus on earnings, especially earnings in the future. Some found margins of safety in discounted cash flow, the difference between the current price and a hypothetical future price that reflects higher earnings in the future. This approach worked for some but not for others (ask Bill Nygren about Washington Mutual).
Buffet used future earnings discounted to the present as one part of his tool kit for finding margins of safety. He also used other concepts like competitive margins of safety through economic moats. An economic moat is an advantage that provides an economic entity a measure of insulation against competitive threats. A monopoly has thicker moats than an oligopoly, for example. Moats that work for protection of an individual firm also work to protect them as a investment.
Similar approaches work in other areas:
It is the rule in war, if our forces are ten to the enemy’s one, to surround him; if five to one, to attack him; if twice as numerous, to divide our army into two.
If equally matched, we can offer battle; if slightly inferior in numbers, we can avoid the enemy; if quite unequal in every way, we can flee from him.
- Sun Tzu (The Art of War)
A standard part of traditional principles of war was the idea of economy of force, of keeping a reserve. In business, an inventory, labelled buffer stock, would be kept:
- Time – The time lags present in the supply chain, from supplier to user at every stage, requires that you maintain certain amount of inventory to use in this “lead time”
- Uncertainty – Inventories are maintained as buffers to meet uncertainties in demand, supply and movements of goods.
- Economies of scale – Ideal condition of “one unit at a time at a place where user needs it, when he needs it” principle tends to incur lots of costs in terms of logistics. So bulk buying, movement and storing brings in economies of scale, thus inventory.
However, during the 1990s, business seemed to have found a new answer: Just in time (JIT). Due to the miracle of digital computers, network communications, and express air delivery, margins of safety were obsolete. Perfect information awareness would remove traditional friction. Supply chains could be dynamically assembled as needed for each product. Products would not be built until they were ordered. Orders would happen realtime over the Internet, bypassing the need for human customer service representatives to take orders. They could be assembled on demand and quickly shipped from any remote corner of the world to its recipient.
JIT leaked into other areas too. One total conquest was in the military establishment. Due to the miracle of digital computers, network communications, and express air delivery, military reserves were obsolete. Perfect battlespace awareness would remove traditional military friction. Shells would not be fired until they were called for. Orders would happen realtime over a digital network, bypassing the need for a large human chain of command. Troop deployments could be assembled on demand and quickly shipped from any remote corner of the world to whoever needed invading.
The follies of the 1990s were visited on the head of the Decade With No Name. The Pentagon invaded Iraq with no strategic reserve. Troops were held in reserve but were being sent into the theater on demand. Assuming there was such a thing as Just In Time Allies, the 4th Infantry Division was held off the coast of Turkey waiting to open a northern front. Then after the war ended, suddenly they found themselves without enough troops to occupy the country and put out fires. They had mastered the first part of Petain’s dictum “Fire destroys; infantry occupies” but failed at the second. The insurgency and later debacles can partially be explained by a lack of strategic and tactical manpower reserves.
There is no margin of safety in pretending to predict the future, especially the far future. Taleb recommends a kind of margin of safety in time and. By not projecting far into in to the future but proceeding through slow, iterative OODA loops, tinkering in other words, you keep yourself from overstretching and exposing your flanks to the telling blow of the Black Swan. As a concrete example, Taleb points out, in the spirit of Graham, that Wall Street tends to take a lot of risk based on a confident assessment that prices will always go up. Computerized risk models compounded the traditional hysteria that feeds the rise of bubbles. Wall Street thought it had discovered a new world of predictive security when all it were doing is writing yet another chapter of Extraordinary Popular Delusions and the Madness of Crowds. Mr. Market is a pied piper.
In a down market, he who keeps his tulips may live to plant another day. However, there’s no guarantee; at minimum, you need a margin of safety in wisdom:
16. And he spake a parable unto them, saying, The ground of a certain rich man brought forth plentifully:
17. And he thought within himself, saying, What shall I do, because I have no room where to bestow my fruits?
18. And he said, This will I do: I will pull down my barns, and build greater; and there will I bestow all my fruits and my goods.
19. And I will say to my soul, Soul, thou hast much goods laid up for many years; take thine ease, eat, drink, and be merry.
20. But God said unto him, Thou fool, this night thy soul shall be required of thee: then whose shall those things be, which thou hast provided?
21. So is he that layeth up treasure for himself, and is not rich toward God.
- The Gospel of St. Luke: Chapter 12
