MARGIN of SAFETY

“In the old legend the wise men finally boiled down the history of mortal affairs into the
single phrase, ‘This too will pass.’ Confronted with a like challenge to distill the secret
1
of sound investment into three words, we venture the motto, MARGIN OF SAFETY.”
– Benjamin Graham

WE THOUGHT IT WOULD BE A USEFUL EXERCISE to review The direct relationship over the long term between
the “first principles” that drive Burgundy’s investment performance and profitability is the reason that the
philosophy. Our approach can best be summarized as identification of high-quality companies with real earnings
making concentrated investments in well-managed, high- (rather than those with only the potential for distant
quality companies that are purchased at significant earnings) is the starting point of our investment process.
discounts to their intrinsic values. Like any investment We look for companies that:
style, it can be out of favour and trail broad benchmarks • sell a product (or products) for which demand is
for a period of time, but we are confident that our stable and recurring,
approach leads to superior investment returns over the • enjoy limited competition, and
long term. • are in industries that have high “barriers to entry.”
Investments always carry short-term market risk, and that Companies possessing these characteristics enjoy a degree
can never be completely eliminated or diversified away. of control over their economic destiny. They have a
We believe, however, that by thoroughly assessing and competitive advantage and therefore strong market
analyzing each company held in our portfolios, business position. These companies usually earn high returns
risk can be minimized. If the investment is then made at a on equity and generate significant free cash flow. This
substantial discount to intrinsic value, then investors will last item, free cash flow, is critical to our evaluation.
truly have found a “margin of safety” that should preserve Accounting earnings alone are inadequate for complete
capital. As Warren Buffett states so clearly, “Rule No. 1: analysis – look no further than the travails of Enron and
Never lose money. Rule No. 2: Never forget Rule No. 1.” WorldCom as examples. A company must generate cash
that can be reinvested in the business or returned to
What are the key characteristics of a high- shareholders in the form of a dividend or a share
repurchase if we are to invest in it.
quality company?
The year 2000 demonstrated why the quality of a company
and its earnings do matter when buying stocks. During
What are the signs of a good management
the height of the technology stock mania (Q3/99-Q1/00), team?
speculators sent the shares of many unprofitable Good management is an integral component of a strong
companies soaring. It was quite a painful period for company. Our evaluation of a company’s management
value investors like Burgundy. Inevitably, the reign of is based primarily on how well they run their business
these stocks was relatively short lived. (i.e., their operating skills) and how they use the earnings
(allocated capital) within that business.

1 Graham, Benjamin, The Intelligent Investor; Harper & Row; New York; Fourth Revised Edition, 1973
 MARGIN of SAFETY
How well they run their business is a relative assessment renowned investor, referred to this frequent event as
versus other management teams in the industry. We compare “diworsification.” Most acquisitions eventually destroy
operating profit margins, returns on capital and any industry- shareholder value (for the acquirer’s stockholders), so
specific operating measures. For example, in a retailing we are very wary of acquisitive companies. We will only
enterprise, same-store sales growth rates would be compared. invest in those companies whose managements have a
But the approach must be more than just a quantitative very disciplined value approach and have a good track
one. We also try to get a sense of the intangible factors that record of integrating acquired companies. Capital should
make a great Chief Executive. Does he love his business? Is be allocated only to those projects that are expected to
she obsessed with driving down costs? Does he enjoy earn a rate of return in excess of the corporation’s
beating his competition? Does she need to win? In our (i.e., shareholders’) cost of capital.
opinion, the most effective way to assess these intangibles
Equally important is management’s candor with shareholders
is by visiting the company and spending time with its
when discussing the business and its prospects. Because
executives. The company’s direction can be examined by
public shareholders are minority owners, they are not
carefully reading its Annual Report and meeting with the
privy to “boardroom discussions,” so corporate insiders
CEO to understand his vision. And very importantly, it
should be sufficiently transparent to their shareholders.
can also reveal whether the company is being managed for
It is crucial that they help owners gain a better
the short-term benefit of Wall Street or the long-term
understanding of the company and the environment in
interests of its own shareholders.
which it operates by explaining the factors that drive
How well management allocates capital is key to our success and those that cause failure in their industry.
analysis. Companies that generate significant free cash A Chief Executive Officer who openly discusses the
flow in excess of their maintenance capital expenditure company’s business risks is usually one who has also
requirements are at the greatest risk of making poor capital considered how to deal with those risks.
allocation decisions – simply because they have the excess
Wall Street often refers to a management having “lost
capital to deal with in the first place.
credibility.” We think that one of the best ways to earn
The capital allocation decision is of particular importance credibility with investors is to rarely “surprise” them with
because, as minority shareholders, we have little control bad news. By introducing the potential for negative
over these policies; control lies with top management. outcomes and the manner in which the company is
Our fear is that a company’s Chief Executive Officer may prepared to address them, a manager engenders
decide to frivolously spend the company’s excess cash; confidence in shareholders, even when manoeuvring
he may buy a couple of corporate jets, construct a through difficult times.
20-storey ‘world’ headquarters or, worst of all, acquire
No matter how much thought executives give to potential
an unrelated, inferior business.
outcomes, they will still make many mistakes throughout
Inferior acquisitions have been a great destroyer of their careers, some small, others large. What differentiates
shareholder wealth. Wall Street investment bankers are good managers from the others is their ability to admit a
only too willing to massage a CEO’s ego by providing mistake has occurred, analyze it, and learn from it. In our
“expert” analysis of acquisition targets, which would own analysis, we believe that we learn more about an
increase the size of the CEO’s domain. They produce industry by studying the mistakes made, rather than the
“independent” valuations showing how much shareholder success achieved, and we highly regard a CEO’s candor in
wealth will be created, even if it often means overpaying these matters. Warren Buffett perfectly encapsulates our
to acquire another company in an unfamiliar industry. views on the importance of straight-talk in the following
So, after the CEO has indulged his ego, and the bankers statement: “The CEO who misleads others in public may
have collected their large fee, the shareholders are usually eventually mislead himself in private.” It is shocking how
left with an unpleasant outcome. Peter Lynch, the often we find this to be the case.

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 MARGIN of SAFETY
Why buy at a discount to intrinsic value? Why make concentrated investments?
The inevitable reversion of excessively high stock prices to At Burgundy, we prefer to make investments in relatively
reasonable levels clearly shows that valuation does matter. fewer companies than the average fund, contrary to the
Ultimately, what counts are the cash flows you earn from conventional view that diversification is the best way to
an asset, the rate at which these cash flows grow and minimize risk. A number of managers use this latter
the interest rate at which they are discounted. When method to diversify away risk mainly because, in our view,
combined, these three factors provide an estimate of a they know very little about the companies in which they
company’s “intrinsic value.” Our investments are based invest. Often, the only result overdiversification guarantees
on a comparison of their cost versus their intrinsic value. is average performance. Instead, we believe that risk can
If the stock price is significantly less than the intrinsic be more effectively reduced by thoroughly researching
value, then we make the investment. We allow for a and understanding companies and their managements,
conservative discount to intrinsic value of at least 30% and then owning a portfolio concentrated in the most
because forecasting the future with absolute certainty is appealing of these investments.
impossible. This large cushion between the price paid and While concentrated value portfolios have produced
our estimate of the asset’s true value provides a “margin above-average, long-term performance, their short-term
of safety” against any unforeseen negative events. results can be more volatile. A portfolio invested in fewer
The fundamental premise of capitalism is that capital securities may experience greater swings against the
moves from low return projects to ones that are expected market average, as compared to one invested in many
to generate the highest risk-adjusted returns. Capital is more securities. Academics refer to this as volatility “risk”
therefore attracted to the most undervalued assets since, and try to diversify it away. We view this volatility as an
as their market price rises to intrinsic value, capitalists opportunity and take advantage of dramatic swings in
earn the highest return on their investment. That is stock prices – especially when they decline. These declines
why value investing has consistently been the most provide opportunities to invest in terrific companies that
successful form of investing over the long run, and why are often unfairly battered by the markets.
the Forbes 400 list of America’s richest people includes
value investors like Warren Buffett and Charlie Munger
Conclusion
(Berkshire Hathaway), Ned Johnson (Fidelity Investments)
and David Gottesman (First Manhattan Co). Invest only when a significant discount to intrinsic value
exists. Invest in high-quality businesses run by capable,
It is important to note that a stock purchased for less than honest, shareholder-minded managers.
its true worth is not expected to immediately appreciate to
its intrinsic value. The same factors that caused the By carefully applying these “first principles” we ensure
undervaluation in the first place (perhaps adverse market that a “margin of safety” is present in every investment
conditions or incorrect investor perceptions) may persist that we make. This approach to investing preserves
for long periods of time. The value investor must have capital and has proven to generate excellent long-term
confidence that in the majority of cases, the situation will investment results.
be rectified. As Ben Graham, the dean of value investing
observed, “In the short run the market is a voting
machine, but in the long run it is a weighing machine.”

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