Having a margin of safety is the cornerstone of intelligent investing. Buffett has said that chapter 20 of Benjamin Graham’s The Intelligent Investor which deals with the concept of having a margin of safety is one of the most important things ever written about investing. That Seth Klarman named his book Margin of Safety tells you something about the centrality of this concept.
Most often, a margin of safety is thought to reside in the gap between the price you pay and the value you receive, and rightly so. In addition, though, a margin of safety can be found in the certainty with which you believe a company will be worth far more in ten years than it is worth today. This is particularly true if you run a focused portfolio.
Buffett has said that he would sell a stock of a business that he was 90% certain would be worth more in the future if he could replace it with a stock of a business whose prospects were 100% certain. Moreover, he has said that he is not in favor of compensating for uncertainty by using a higher discount rate, which he views as nonsense. This notion of finding a margin of safety in certainty is essentially a positive embodiment of the famed first rule of investment, namely don’t lose money.
Commenting on when he was on Coke’s board, Buffett once said that, although he understood why it was done, he didn’t see much point in doing an ROI analysis on Coke’s prospective investments in growing the business because of his supreme confidence that the returns would be more than satisfactory.
If you want to beat the market, spend time looking for companies that you are virtually certain will be worth far more in ten years than they are today and then patiently look for an opportunity to buy shares at a reasonable price. Be patient and don’t commit your capital at prices that will lock you into mediocre returns. On the other hand, be reasonable. Businesses of this caliber rarely sell at deeply distressed prices.