Margin of Safety

December 31, 2011

“As soon as there is life there is danger.” – Ralph Waldo Emerson

We recently met with a distinguished professor of Economic History and Macroeconomics and explained our investment approach using the Ewing Morris & Co. Investment Playbook (see our November 2011 letter) and company-specific case studies.  As our meeting concluded, the professor told us he found it refreshing that we did not once mention macroeconomic issues.

Unlike the professor, most people we meet ask us what we think about the broad economy, issues in Europe or some other reason to justify minimizing their investments in equities.  We always give the same answer – we don’t know.  This is not because we think the questions are unimportant but rather believe that the answers to these questions are unknowable.   Instead of providing a speculative guess we attempt to solve this problem of inherent uncertainty in a different way.

Consider the approach of the engineer: when designing a bridge intended to carry a thousand ton load, the engineer recognizes that, in nature, the unexpected (i.e. floods, earthquakes, hurricanes, etc.) happens and therefore includes an extra “margin of safety” that ensures the bridge can actually hold a much larger load, perhaps two thousand tons. The appropriate margin of safety depends on the situation – for example a bridge in an earthquake zone like San Francisco would require a larger margin of safety than a similar bridge in Saskatchewan.

We apply the same margin of safety principle when we make investment decisions. We feel secure in our decisions because we recognize the inevitability of unpredictable events such as economic crises, natural disasters, political events and new technologies. Instead of trying to predict when the next crisis or recession will occur, we simply assume that it will happen soonand prepare accordingly. One investment factor that is within our control is the price we pay to own a business. If investment success requires nothing less than perfect conditions, it is simply not cheap enough to be of interest.

This approach does not guarantee investment success but it is the best method we know to avoid losses and preserve capital, which is the first step in making money with investments.

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