Margin of safety 2.0

An overarching error-proofing mindset, not a final valuation check

I heard about Poka Yoke from my father when Japanese manufacturing techniques first came to the Indian auto component industry. To a goofy kid, the idea of mistake-proofing every jig, workstation and worker was fascinating. The idea of ‘quality at source’ every step of the way seemed so much more sensible than quality as a last stage check.

At engineering college, my greatest learning came in my first lab course. After careful experiment, each group turned in a report proudly showing measured gravity to be 9.8m/s2, only to have it instantly returned with 0/10 marked in big red letters. The drama was deliberate, to make us return to the lab bench, check each instrument for its precision and gauge additive or multiplicative nature of errors across stages. Appreciating errors at each stage led to a more humbling result of 10 (+/- 1).

As a practicing engineer, I wanted to design the fastest circuits possible. Ever paranoid Intel wisely preferred slower circuits that worked reliably when tens of millions of chips were mass produced. I spent more time checking circuits for failure under different conditions than speeding them up. Though my engineering was forgettable and forgotten, I internalized an appreciation for safety margin at each step of the way. I see why Romans made engineers stand under their bridge as vehicles drove on it.

In contrast, I’ve rarely seen error bars in finance or economics. Even bogus metrics with Greek labels have high decimal-point accuracy. A renowned finance professor valued a tech start-up using a cost-of-capital that had two decimal points. He confidently said that he could look up cost of capital for any company in the world with the same accuracy from a table he had made (up).

When I eventually stumbled onto Benjamin Graham’s teachings, his emphasis on margin of safety resonated with the engineer in me. In letter, margin of safety was one of three timeless investment concepts that he elucidated (along with intrinsic business value and Mr Market). In spirit though, margin of safety was all-pervasive in his teachings as he embedded it into the other two ideas as well. While procedural aspects of calculating intrinsic value were specific to his context, the philosophy behind his techniques was to embed conservatism into its calculation. Similarly, his idea of only being informed by a (crazy) market without being influenced by it offered a behavioral safety-margin. By entirely ignoring markets except when they accidentally offered an actionable price, investors can be singularly focused on businesses without getting swayed by prevailing sentiments. While Graham’s best disciples modified his techniques as their context shifted from commoditized to enduring businesses, they retained his philosophical tenets, with margin of safety underpinning everything they did.

While every investor knows of Graham and his writings, most pay lip service to margin of safety, without adhering to its true spirit. They treat margin of safety as purely a valuation check, to be applied at the final stage of a process that’s often reckless at prior stages. Investors layer brave assumptions onto a so-so business to make fairy-tale forecasts. Once a model spits out numbers high enough to rationalize an investment decision, they claim margin of safety leaving Graham spinning in his grave.

In spirit, margin of safety is an overarching error-proofing mindset rather than a final valuation check. It is better approached in an engineering sense rather than a financial sense. It is inbuilt at every stage of analysis: understandable businesses; trustworthy owners; attractive industry; long track record; strong competitive position; defensible construct; robust balance sheet; no reliance on charity of strangers. Failures at these stages are multiplicative and can have dramatic non-linear impact on business value and investment outcome. As an illustration, a dodgy aggressive NBFC unravels rapidly in bad times and falls into a death spiral as wholesale funding dries up. If and only if all these stages offer safety-margin does one even get into valuing the business. A final layer of safety is added by linking valuation to real financials, in an empirically-grounded manner. Except the final stage, every check is qualitative, asking the question “Safe enough?”. If one gets these checks right, an inadvertent error at the last stage is likely to be small and linear. One may overpay 10-20%, but is unlikely to be stuck with a business that goes to zero. [Getting prior stages right isn’t a license to overpay. The notion of buying great businesses at any price is dangerous nonsense.]

In spirit, margin of safety is really ‘safety at source’ every step of the way rather than a last-stage check. Poka yoke investing, anyone? 

(Originally published in February at https://www.linkedin.com/pulse/margin-safety-letter-spirit-anand-sridharan/)