During the annual Burgundy Information Session via conference call this Fall, Richard Rooney, President and CIO, was asked to explain the concept of margin of safety. Here is his response.
With every company we look at, we calculate what is called an intrinsic value. That is notionally the price at which we would buy or sell the whole business. It is based on discounted cash flow analysis – essentially we run out, usually over five years, what we think is a fairly predictable outlook for the company, then we assume a terminal growth rate that is usually quite low (between 0-2% from then on in) and we discount back that stream of cash flows. We usually discount it back at around 8-8.5%. We have been using that number since 1995.
If you really wanted to mess around, by the way, all you have to do is change that number by even 1% and all of a sudden it is a glorious buying opportunity. But we don’t do that. The 8-8.5% is what we would like to see from a company so that is what we will discount by.
The margin of safety is the discount to intrinsic value in an individual stock or portfolio. So, if we calculate the intrinsic value of a company at 100 and it is trading at 70, then that’s our 30% discount – that is where all the green lights flash and where we want to buy the company. Usually we only get opportunities to buy at that 30% discount during a recession or a market panic. In 2002-03 and 2008-09 we had the opportunity. For most of the market cycle you will see that margin of safety get smaller and smaller, then bounce around late in the cycle.
Unfortunately, unless the margin of safety is extremely high, it’s not predictive. So, if it’s 40% margin of safety, then I can tell you two things:
- The trailing numbers in the portfolio really look bad
- You are about to make a lot of money
But when they get down below 20%, it is hard to predict where they are going to go. When they get quite thin then you can expect eventually the music is going to stop, but we just don’t know when.
In 2008-09 margins of safety were the highest they have been in Burgundy’s history – it was an extraordinarily cheap market. Then there was a very rapid advance back in 2009-10, and since then our portfolios have generally been appreciating nicely and therefore we have seen that margin of safety gradually decline. By the summer of 2014, they were really skinny – back to 2007 levels. At that level, you start to get concerned. And now, with some fairly healthy drops in the market, we are back to more comfortable levels for this time in the business cycle.