Margin of Safety
Saturday, 8/16/2025 09:01
Investing beyond the casino...
IF YOU want the thrill of the casino, go visit a casino,
writes Tim Price at Price Value Partners.
But given that most of us, when it comes to our investments, are dealing with irreplaceable pots of capital, our life savings, it probably makes sense to adopt an approach to "the Great Game" that almost completely strips emotion out of the process.
We've discussed in the past Harry Browne's 'Permanent Portfolio'. The bespoke discretionary portfolios that we manage are not slavishly tied to the Permanent Portfolio, but they are certainly relatives of a sort.
As a reminder, Browne advocated a portfolio approach "for all seasons". He recommended putting a quarter of your assets into cash, another quarter into bonds, another quarter into stocks, and a quarter into gold.
The reasonable premise – at least when he offered this approach back in the 1970s – was that each segment of the portfolio provided something distinct by way of risk attributes and each segment protected investors against different economic outcomes.
Cash and bonds were deflation hedges; equities were a claim against the real economy and would likely perform well during periods of modest inflation; gold would protect against an unruly outbreak of high inflation or a systemic shock. Browne recommended rebalancing the portfolio annually to maintain those 25% target weights.
The problem today, of course, is that the world has changed out of all recognition compared to the world that Browne knew. Browne died in 2006. He did not live to see the global financial crisis that ignited during the following year, nor the shock reduction in interest rates, nor the colossal experimentation in government and corporate debt purchases as part of quantitative easing. So he did not live to see a world in which fully half of the Permanent Portfolio – both cash and bonds – became essentially obsolete.
The primary investment objective of our managed portfolios is capital preservation, in real terms, followed closely by absolute (that is to say, positive) returns.
Bonds – whether government or corporate – we consider uninvestible. They are now the opposite of riskless assets. They are the financial equivalent of insects in search of windscreens.
Cash may not contribute meaningfully to a portfolio return in 2025, but it does give you optionality. It gives you a choice. It offers you dry powder for when real, compelling investment opportunities present themselves. Right now they are somewhat thin on the ground.
In terms of direct investments, what we look for are high-quality businesses run by principled, shareholder-friendly executives with a proven ability to allocate capital well. If they are in the form of family-owned businesses, so much the better. Family-owned and family-run businesses tend not to play the Wall Street game, and can therefore concentrate on capital preservation and capital growth over the longer term. If it's possible to buy shares in such companies at no great premium, again, so much the better.
If we're looking at individual companies, we define value starting with margin of safety. It means specifically:
- 10% cashflow from operations (CFO) yield
- Price / earnings < 15
- Price / book < 1.5x
- Debt: Total Assets < 30%
- Cash from Operations growth
- Return on Equity > 8% per annum on average
- Share buybacks at appropriate valuations.
The legendary value investor Benjamin Graham coined the phrase "margin of safety" to denote the fundamental characteristic of stocks that he was most interested in acquiring. Ben Graham was an absolute return type of investor. He wasn't interested in beating the market so much as in securing decent returns and preserving capital. As he himself said (emphasis ours),
"An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative."
Note those words. Graham clearly distinguishes between investing (and the attendant thorough analysis required), and speculation. If you are buying the market using a cheap exchange-traded fund, you are getting cheap market access, but you are also getting a portfolio of indiscriminately selected stocks that will depend for its future returns on the market continuing to go up. You are, in other words, speculating without realising it.
At a time when debt markets cannot be trusted, we see especial merit in absolute return and uncorrelated funds. Our favourites here are systematic trend-following funds, primarily because of that word uncorrelated. Their returns have historically been weakly correlated to the performance of stocks and bonds, or not correlated at all.
If you want a balanced and properly diversified portfolio, you want your component parts to be uncorrelated to each other. For some years now, stocks and bonds have essentially been joined at the hip, their prices increasingly driven higher as interest rates have collapsed, courtesy of our friends at the central banks. But what happens when interest rates and inflation start to rise – perhaps in a disorderly manner?
We have written of late of our concerns about inflationary pressure. If inflation does turn out to be a higher risk factor, or if you are simply seeking portfolio insurance for your cash and other investments, then all roads lead to gold, and precious metals more generally.
Our favourites are the monetary metals, gold and silver, because we are increasingly concerned about the possibility of central banks losing the confidence of market participants in the paper money system. Gold and silver, to our thinking, are not so much commodities as alternate forms of money that, unlike conventional money, cannot be printed on demand.
Investors in gold have fared well since the US Dollar was unyoked from gold in 1971 under Richard Nixon. But we have to acknowledge the extent of drawdowns (peak to trough losses in price). The post-1980 drawdown in gold was brutal. As was the post-2011 drawdown.
To stay in gold, you need to have a strong constitution. But if our fears about our monetary system (and the likelihood of Modern Monetary Theory being rolled out) are correct, it will warrant a place in any investor's portfolio over the years to come.
Modern economics has claims to being a science. It is not, in fact, a science at all. Nor can it be, not least because it fails to fulfil the definition of science offered by the one practitioner, perhaps, who more than anyone else helped to popularise science during the 20th century.
Richard Feynman's scientific method refers to a process of thought based on integrating previous knowledge, observation, measurement and logical reasoning:
"Now I'm going to discuss how we would look for a new law. In general, we look for a new law by the following process. First, we guess it [audience laughter], no, don't laugh, that's the truth. Then we compute the consequences of the guess, to see what, if this is right, if this law we guess is right, to see what it would imply and then we compare the computation results to nature or we say compare to experiment or experience, compare it directly with observations to see if it works.
"If it disagrees with experiment, it's wrong. In that simple statement is the key to science. It doesn't make any difference how beautiful your guess is, it doesn't matter how smart you are who made the guess, or what his name is...If it disagrees with experiment, it's wrong. That's all there is to it."
If it disagrees with experiment, it's wrong.
So in response to the concerns facing all of us, we try and behave as scientifically as possible. In the context of overall asset allocation, we believe in diversification. You may not wish to use the same sort of allocations to the above asset classes that we do, but the important thing is to maintain some diversification over time, because the future is simply uncertain.
And at the level of individual stocks – still the bedrock of the portfolio – we try to follow Ben Graham's precept: "Buy not on optimism, but on arithmetic". Buy good companies at cheap enough prices and you will seldom go far wrong.
Meanwhile, we are all beset by news flow and any number of variously rational – and irrational – fears. Which is why one tenet that we increasingly focus on is a belief in limiting your exposure to news altogether. Avoid dangerous and pointless distractions about things you can't change anyway.
As Richard Feynman said, "The first principle is that you must not fool yourself – and you are the easiest person to fool."
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