Margin Of Safety And Moat: 2 Factors Of A Good Investment
I have read books, articles, podcasts and other resources about Warren Buffett, Benjamin Graham, Seth Klarman and Mohnish Pabrai. The common thing about their investment philosophies is that they emphasize the importance of a margin of safety and moat.
In this post, I’ll discuss about why these 2 factors are important in determining a good investment.
What Is An Economic Moat
According to Warren Buffett, a truly great business must have an enduring “moat” that protects excellent returns on invested capital. In real life, moats are deep trenches filled with water built around a castle that acts as a barrier to protect against invading enemies.
Fig. 1 A Castle Moat
In the business world, an economic moat is acts as a barrier that protects the business from invading competition. The wider the moat, the harder it is to penetrate the company’s economic advantage.
Companies with economic moats thrive better than their competitors. The reason behind it varies but may include factors such as a strong brand, patented technology, regional monopolies and other such things.
A strong brand is considered a moat because it represents something unique that loyal customers tends to value more than anything else. The same is true with a patent. Regional monopolies are also considered as moats as it give companies a strong advantage because of regional control.
Buffett looks for businesses that has a wide enduring economic moat around it. He avoids businesses with weak or temporary moats. He want businesses that he easily understands, has favorable long-term economics, a management with integrity and a stock that is priced that makes business sense.
How Moats Protect Businesses Against Capitalism
It is natural for businesses to compete at each other. To fight competition, a business should have something that the others don’t have. Buffett calls this a competitive advantage. This competitive advantage or ‘moat’ makes the business difficult to copy.
The ability of a competitive advantage to endure long periods of time through good times and bad and still continues to earn a solid profit protects the business from competition. Buffett believes that a business with a strong economic moat protects its returns on invested capital.
What Is A Margin Of Safety
Another thing common to the famous investing personalities I mentioned above is that they all use the concept of Margin of Safety. The concept is fairly simple.
According to Seth Klarman, a margin of safety is achieved when stocks are bought below their underlying value to allow for error. By allowing room for errors, this will avoid huge losses overtime due to volatility, valuation errors and the unpredictability of the future.
Investors achieve a margin of safety by;
- buying at a discount to underlying business value.
- selling when the price reflects its underlying value.
- holding cash until attractive investments comes along.
How Margin Of Safety & Moats Define A Good Investment
This is fairly straightforward. By putting in a margin of safety, you increase downside protection. And when you consider a company’s moat, you then increase your upside earnings potential.
A business that has a strong moat will eventually generate more profits and grow much faster because it will prevent any competitor into taking away its profits. On the other hand, by employing a margin of safety, you reduce the risk of uncertainty and human error.
Now what happens when you buy a business with a strong moat and put in a margin of safety? Well, you end up with a wonderful investment.
Final Thoughts
That’s about it! I summarized the important facts about margin of safety and moats I learned from valuable resources out there.
I hope that this gives you a basic understanding of what they are all about. I use these 2 factors in determining my stock picking decisions. I believe that a successful investment should contain a strong economic moat to protect it from competition and that you should buy it with a margin of safety to protect you from valuation errors. This what makes value investing rewarding.
Have you bought your investments based on these two distinct factors? Or have you found a suitable investment that you think has a very wide moat around it? Do you prioritize risk by putting in a large margin of safety? If you’re using these factors in your stock picking decisions, then kindly share your thoughts below.
Happy investing!