Warren Buffett distills investment success into three words — “margin of safety” — and tells investors to take one of two approaches: either focus on value or buy an index fund. Buffett, the “Oracle of Omaha,” has been steadfastly giving such advice for decades, through calm and choppy markets alike.
In fact, 20 years ago I hosted Buffett and Charlie Munger, his Berkshire Hathaway BRK.A, +0.00% BRK.B, +0.08% partner, for two days of debate that was recorded in my book, “The Essays of Warren Buffett: Lessons for Corporate America.”
At the time, Buffett’s investing style was out of fashion. Critics said the Oracle had lost his touch, misunderstanding the go-go “new economy” and its “game-changing” technology. But Buffett foresaw exceedingly high stock prices — which soon proved correct. Moreover, two decades later his value-based investing style has not only survived, but thrived, due in large part to three pivotal components:
First, margin of safety refers to paying a low price compared to value obtained. In theory, there is no difference between stock price and business value: if markets are efficient, then prices are good estimates of value. But investors like Buffett laugh at this efficient markets theory; at the symposium, Munger labeled it “twaddle” and “gibberish.”
Buffett and Munger say that market prices gyrate above and below business value. In the 1950s, Buffett’s Columbia University professor, Benjamin Graham, offered the image of the market as a manic-depressive veering from euphoria to gloom, though the reality is neither wonderful nor awful.
So avoid overpaying and buy low, Buffett and Munger say. But don’t go to extremes; it’s better to buy a great business at a fair price than a fair business at a great price, Munger has famously quipped.
At the 1996 symposium, held in New York at Cardozo Law School, the Berkshire executives referenced some of their earliest and savviest purchases, such as shares of the Washington Post Company in 1973-74 at a price about 1/5 of its value. Today, look to Berkshire during the financial crisis of 2008, as it invested throughout corporate America, from Goldman Sachs Group GS, -0.43% to USG Corp. USG, -3.42% , at prices yielding enviable margins of safety.
Second, focus on exceptionally valuable companies, those already run successfully, rather than turnaround prospects. After all, change is both difficult and uncertain. Buffett explained at the symposium: “We try to buy into businesses with excellent economics, run by honest and able people at a decent price. We buy very few securities, so we look at it as ‘focused’ investing.”
In annotations I solicited for The Buffett Essays Symposium, the author Robert Hagstrom writes: “Warren popularized the concept of ‘focused investing,’ a portfolio management approach that concentrates one’s bets on those stocks that have the highest probability of beating the market over the long-term.”
Shareholder activists and venture capitalists manage for change but, as Munger warned at the symposium, doing so creates “complicated legal problems” he’d rather avoid. Buffett meanwhile stressed that these decisions arise from needing an “exit strategy.” In contrast, he said, Berkshire looks for a “non-exit-strategy — things we’ll never want to exit.”
Non-exit businesses are those commanding competitive advantages that deter rivals and withstand technological onslaughts for years, such as barriers to entry or brand strength. Buffett calls these features “moats,” like medieval defenses fortifying castles. Such quality businesses are desirable when run by people you like, trust and admire — individuals you’d be happy to have your child marry, Buffett advises.
Finally, know your limits and avoid investment targets outside what Buffett dubs your “circle of competence.” So if you cannot make required judgments — about value, moats, and managers — then invest through low-fee index funds. Doing so beats the after-cost results most professionals deliver. As they say in poker, “If you’ve been in the game 30 minutes and don’t know who the patsy is, you’re the patsy.” Buffett implores you: Don’t be the patsy.
At the 1996 symposium, Bill Ackman, then a little-known investment novice in our audience, challenged index investing as a social practice and defended what would become his brand of shareholder activism. Ackman contended that as more capital is indexed — and voted algorithmically for average returns — too much is staked in larger companies just because they are in the index. Munger, moderating the symposium’s investing panel, concurred: “You are plainly right. If you pushed indexation to the very logical extreme, you would get preposterous results.”
On the other hand, countered Jeff Gordon of Columbia University, index fund operators actually have incentives to promote superior governance and performance across the board. As long-term owners with large stakes, he reasoned, “They are a bit like Charlie and Warren,” whose focused investing influences manager behavior. So more indexing through big players may be better for all of us — except perhaps the most sophisticated. Concluded moderator Munger: “Well, ladies and gentleman, you have just heard a very subtle and profoundly correct point.”
Following up on the symposium, in an interview with Forbes magazine, , I credited Graham with designating “margin of safety” decades earlier as the key to investment success. I said Buffett still agreed. That remains true now, 20 years later, and that simple pearl of wisdom will likely remain the key for decades to come. All investors— focused, activist, or indexed — can thank Ben, Warren, and Charlie for this perpetual payoff.
Lawrence A. Cunningham, a professor at George Washington University, has written extensively on Berkshire Hathaway, Warren Buffett, and investing, including as editor of The Essays of Warren Buffett: Lessons for Corporate America and the newly-released The Buffett Essays Symposium: Annotated 20th Anniversary Transcript.