It would be a mistake to think that all the facts that describe a particular investment are or could be known. Not only may questions remain unanswered; all the right questions may not even have been asked. Even if the present could somehow be perfectly understood, most investments are dependent on outcomes that cannot be accurately foreseen. – Seth Klarman -
Klarman describes it well. There is a lot of uncertainty investors must deal with in every investment. You can never know all there is to know. And you can and will make mistakes. For these reasons, I love Graham’s concept of a margin of safety.
The margin of safety concept is the idea that you want to buy an investment at a price that gives you room for uncertainties and errors. As Benjamin Graham David and Dodd say:
The safety sought in investment is not absolute or complete; the word means, rather, protection against loss under all normal or reasonably likely conditions or variations . . . . A safe stock is one which holds every prospect of being worth the price paid except under quite unlikely contingencies.
Buffett describes the margin of safety this way: “When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 – pound trucks across it. And that same principle works in investing. ” The best way I’ve found to ensure some margin of safety in your investments is to think about asset values — indeed, a focus on buying tangible assets at a discount is a great way to lower risk and still enjoy sweet returns.
What are tangible assets? These are the things you can see, touch, and count — things like buildings and real estate, cash, barrels of oil, hydroelectric dams, water rights, timberlands, factories, and more. Perhaps it is easier to understand tangible assets by comparing them to intangible ones. Intangible assets are things like goodwill, development costs, and even licenses or brand names.
And what do I mean by buying tangible assets at a discount? By “discount” I’ m referring again to the two- market model. We know the stock price in the publicly traded market. That is the market we are going to buy from or sell into, as the case may be. But we don ’ t have to accept that price as an accurate statement of value. So in trying to figure out if we can buy at a discount, we have to try to break down our investments into pieces we can understand, compare these pieces to private market values, and therefore value the whole.
In my newsletter, I’ve always expressed a preference for buying tangible assets, which is a great opportunity when you can find it. Buying tangible assets is a high – percentage play.
Let me again borrow from Klarman, who writes in his book:
Tangible assets . . . are more precisely valued and therefore provide investors with greater protection from loss. Tangible assets usually have value in alternate uses, thereby providing a margin of safety. If a chain of retail stores becomes unprofitable, for example, the inventories can be liquidated, leases transferred, and real estate sold.
Conversely, when it comes to buying a well – known soft – drink company like Dr. Pepper, you will probably wind up paying a high price relative to its underlying book value, because the market gives a lot of value to — or credit for — the Dr. Pepper brand. But, as Klarman says, “ if consumers lose their taste for Dr. Pepper, by contrast, tangible assets will not meaningfully cushion investors ’ losses. ”
Here he is emphasizing the role of tangible assets in creating a cushion to protect against adversity — again, a margin of safety. We’ll see that buying companies with loads of tangible assets can also be a source of future wealth creation.
So how do we think about asset values?
The first proxy is simple book value, which, counter to its name, is not a value per se. This number is readily available and is simply a product of accounting conventions. Still, it is a good starting place from which you can make adjustments. You can find book value on most financial sites. Or you can look at a balance sheet and use the total stockholders’ equity number. (If you prefer to think in terms of book value per share, you can just take the total stockholders’ equity number and divide it by the total number of shares outstanding.)
The first adjustment I make is to strip out intangibles. I always work with a tangible book value — for the reasons we’ve just covered. Once you have that, you can mark down any other assets you think are not worth much, or you can add value to assets that are not on the balance sheet or are not valued at current market prices.
The classic example is a company that bought real estate years ago and now is sitting on property that has doubled or tripled over that time: accounting convention requires that these assets be depreciated over time, or written off little by little every year. IRSA carried that big parcel of land on their books at $ 39 million. That was the price they had paid years before. The land was now worth probably 15 times that amount.
The essential idea is to go over a company’ s balance sheet, think about the company’s assets, and try to put some values in those assets.
Even if you make only minimal adjustments — even if all you do is use tangible book value — you ’ ll already be ahead of most investors. At worst, using only the simple price – to – book value is not a bad anchor to windward, if you also pay attention to the other factors we’ve covered — like cash flow. So now you have three important concepts introduced:
1. Think about whole companies.
2. Think about cash flows.
3. Think about asset values.
