From Seth Klarman, via Margin of Safety:
Even among value investors there is ongoing disagreement concerning the appropriate margin of safety. Some highly successful investors, including Buffett, have come increasingly to recognize the value of intangible assets – broadcast licenses or soft-drink formulas, for example – which have a history of growing in value without any investment being required to maintain them. Virtually all cash flow generated is free cash flow.
The problem with intangible assets, I believe, is that they hold little or no margin of safety. The most valuable assets of Dr Pepper/ Seven-Up, Inc., by way of example, are the formulas that give those soft drinks their distinctive flavors. It is these intangible assets that cause Dr Pepper/ Seven-Up, Inc., to be valued at a high multiple of tangible book value. If something goes wrong – tastes change or a competitor makes inroads – the margin of safety is quite low.
Tangible assets, by contrast, are more precisely valued and therefore provide investors with greater protection from loss. Tangible assets usually have value in alternate uses, thereby providing a margin of safety. If a chain of retail stores becomes unprofitable, for example, the inventories can be liquidated, receivables collected, leases transferred, and real estate sold. If consumers lose their taste for Dr Pepper, by contrast, tangible assets will not meaningfully cushion investors’ losses.
How can investors be certain of achieving a margin of safety? By always buying at a significant discount to underlying business value and giving preference to tangible assets over intangibles. (This does not mean that there are not excellent investment opportunities in businesses with valuable intangible assets.) By replacing current holdings as better bargains come along. By selling when the market price of any investment comes to reflect its underlying value and by holding cash, if necessary, until other attractive investments become available.
Investors should pay attention not only to whether but also to why current holdings are undervalued. It is critical to know why you have made an investment and to sell when the reason for owning it no longer applies. Look for investments with catalysts that may assist directly in the realization of underlying value. Give preference to companies having good managements with a personal financial stake in the business. Finally, diversify your holdings and hedge when it is financially attractive to do so.