“If you were to distil the secret of sound investment into three words”, we venture the motto, MARGIN OF SAFETY.”– Benjamin Graham
The Margin of Safety
This concept is widely used by the great Benjamin Graham. He used it mainly in an investing capacity.
However, this is a POWERFUL principle that can be applied to investing, decision making, and building businesses.
An Engineering Concept
Its roots are in the Engineering discipline. This is an engineering concept describing the structural capacity of a system beyond the expected loads or actual loads.
Benjamin Graham was one of the founders of this concept as it applies to investing.
It is a straightforward concept and can be applied to anything.
Let's first take a simple hypothetical explanation of the concept, applied to white water rafting.
The Margin of Safety, as it Applies to a Rafting Trip
So you want to go on a rafting trip without a life jacket. That may excite some thrill-seekers, but the average person will want that life jacket.
In this situation, that life jacket has a margin of safety component. Many other factors come into play that increases or reduce the margin of safety.
- Can the person swim?
- If so, how well?
- Where does the chosen River Fall in the rating scale, Class 1, or Class 5?
If you are a good athlete, expert swimmer, wearing a life jacket, and rafting on a Class 1 Rapid, there is a LARGE margin of safety.
Each component that is taken away REDUCES how significant that margin is.
On the flip side, if you can't swim, don't wear a life jacket, and are rafting on Class 5 rapids, your margin of safety is MUCH smaller.
In this case, each component that is added DECREASES your margin of safety.
The Margin of Safety, as it Applies to Business
Now let's apply the concept to purchasing a business. There are several factors at play here when it comes to the margin of safety. Price, terms, leverage, legal exposure, and due diligence are just a few.
Let's take another hypothetical situation and compare:
Two buyers; each wants to purchase a business. Everything is exactly the same except for their legal exposure.
Buyer 1 bought the company properly, owns 100%, and has personally guaranteed the financing.
Buyer 2 bought the business properly, owns 75% of it, and has a strong financial partner for the remaining 25%.
Additionally, the financial backer has guaranteed the financing so that they are not personally exposed if the wind changes directions.
After all, no one goes into Venture, thinking that it's going to fail.
Buyer 2 will be much better off as his margin of safety is more significant. He is aggressively protecting the downside.
The Margin of Saftey, as it Applies to Real Estate
In the world of commercial property, companies usually overestimate rents and underestimate expenses.
Wanting to get into a deal so badly that the facts are ignored is foolish. It is better not to get into a deal at all then get into a bad one.
A margin of safety is a way to keep emotions out of the purchasing process.
Internally, the goal is to have a strict set of investment criteria and add this component to the mix to help you quickly filter through the bad real estate deals.
This way, you are making decisions base on filters that minimize your RISK, hence INCREASING your margin of safety.
Many variables could be looked at, but for simplicity's sake, let's look at rent and expenses.
You would want to do a rent & cost analysis of where the property sits first. So you are looking at the current rents and the current expenses.
At this point, you would deduct the current rents by 20%. With expenses, you want to raise them by 20% from where they currently sit. This is an example of increasing your margin of safety on RENTS and EXPENSES.
If the numbers still work with these two components, it is a winner. If they don't, the deal dies.
Simple concepts are often over complicated. The beautiful thing about the margin of safety concept is that it can be applied to everyday life.
Taking something that is applicable daily is more comfortable to master over time, which can help you to make better decisions with less emotion.
So, practice using the concept, whether it is in your personal, business, or investment life.
The more you engrain the concept into your daily life, the easier it will be to make sound decisions creating a better overall balance in your life.