Real Margin

Over a ten year period the typical excess of stock earning power over bond interest may aggregate 50% of the price paid.

This figure is sufficient to provide a very real margin of safety- which, under favorable conditions, will prevent or minimize a loss. If such a margin is present in each of a diversified list of twenty or more stocks, the probability of a favorable result under “fairly normal conditions” becomes very large. That is why the policy of investing in representative common stocks does not require high qualities of insight and foresight to work out successfully. If the purchases are made at the average level of the market over a span of years, the prices paid should carry with them assurance of an adequate margin of safety. The danger to investors lies in concentrating their purchases in the upper levels of the market, or in buying nonrepresentative common stocks that carry more than average risk of diminished earning power.

As we see it, the whole problem of common stock investment under 1972 conditions lies in the fact that “in a typical case” the earning power is now much less than 9% on the price paid.* Let us assume that by concentrating somewhat on the low multiplier issues among the large companies a defensive investor may now “Margin of Safety” as the Central Concept of Investment

• Graham elegantly summarized the discussion that follows in a lecture he

gave in 1972: “The margin of safety is the difference between the percentage rate of the earnings on the stock at the price you pay for it and the rate of interest on bonds, and that margin of safety is the difference which would absorb unsatisfactory developments. At the time the 1965 edition of The Intelligent Investor was written the typical stock was selling at 11 times earnings, giving about 9% return as against 4% on bonds. In that case you had a margin of safety of over 100 per cent. Now [in 1972] there is no difference between the earnings rate on stocks and the interest rate on stocks, and I say there is no margin of safety . . . you have a negative margin of safety on stocks . . .” See “Benjamin Graham: Thoughts on Security Analysis” [transcript of lecture at the Northeast Missouri State University business school, March, 1972], Financial History, no. 42, March, 1991, p. 9.acquire equities at 12 times recent earnings-i.e., with an earnings return of 8.33% on cost. He may obtain a dividend yield of about 4%, and he will have 4.33% of his cost reinvested in the business for his account. On this basis, the excess of stock earning power over bond interest over a ten year basis would still be too small to constitute an adequate margin of safety. For that reason we feel that there are real risks now even in a diversified list of sound common stocks. The risks may be fully offset by the profit possibilities of the list; and indeed the investor may have no choice but to incur them-for otherwise he may run an even greater risk of holding only fixed claims payable in steadily depreciating dollars. Nonetheless the investor would do well to recognize, and to accept as philosophically as he can, that the old package of good profit possibilities combined with small ultimate risk is no longer available to him.* However, the risk of paying too high a price for good quality stocks-while a real one-is not the chief hazard confronting the average buyer of securities. Observation over many years has taught us that the chief losses to investors come from the purchase of low quality securities at times of favorable business conditions.