The Business of Value Investing: Six Essential Elements to Buying Companies Like Warren Buffett

Chapter 3. The Six Elements of Intelligent Investing

One of the many unique and advantageous aspects of value investing is that the larger the discount from intrinsic value, the greater the margin of safety and the greater the potential return when the stock price moves back to intrinsic value. Contrary to the view of modern portfolio theorists that increased returns can only be achieved by taking greater levels of risk, value investing is predicated on the notion that increased returns are associated with a greater margin of safety, i.e., lower risk.

—The Partners of Tweedy Browne

Imagine for a moment that you're a real estate investor and that a series of tropical storms has caused beachfront houses in Hawaii that were once selling for $2 million to now sell for $400,000 apiece. How many would you buy?

After you determined that the construction was solid and that the land doesn't sit on a toxic dump, you probably would jump in and buy as many as you could afford. While the threat of another tropical storm exists, it's also expected and factored into the cost of construction and insurance. Even if the houses only were to get back to a value of $1 million in a couple years, you would still do very well. The process behind this purchase is completely rational. You paid $400,000 for an asset that was selling for $2 million. Because the discount was so wide, you weren't concerned with whether the price would ever again reach $2 million. Your margin of safety was so high that even at a ...