What is Margin of Safety?

Yesterday, I read Seth Klarman's book "Margin of Safety". I approached that book to answer some of my questions. But, rather, it increased my doubts on numerous accounts. Seth Klarman tries to dig deep into the concept of "Value Investing" and then through Margin of Safety, tries to discuss on value investment approaches. Primarily, it was all about "Discounted Cash Flow " model. The only shortcoming which I felt was that Seth Klarman didn't talk anything about business models. He didn't say anything about "Why a certain business model must be favoured?". Though he talked about the importance of cash flows, but he ignored discussing about the choice of businesses.

First, we'll discuss what is "Value Investing"? Value Investing is all about buying a business by discounting future cash flows to the current prices, and thus evaluating, whether its cheap or expensive to buy into that business. Its definitely the most rational approach to buying businesses. I believe that people who are genuine value investors will be only active in economic downturns. Because its the only time when genuine value investors will be able to find excellent businesses at value. In good market situations, you'll only find poor companies at  discounted cash flow valuations. By "excellent" and "poor", I'm referring to business models, businesses with efficiency ratios. By excellent, I mean a business with excellent return ratios, like decent RoCE, low Debt/Equity & low Cash Conversion Cycle and vice-versa. I assume that the choice of business is also very important. So, if we refine the definition of "Value Investing", it'll be buying a good business with excellent ratios by discounting future cash flows to the current prices and thus evalauting whether its cheap or expensive. What I'm suggesting here is that in good market conditions, good businesses happen to trade at rich valuations and hardcore value investors willn't lay their hands upon them at that time. It'll be only during economic downturns that die-hard value investors will go for grabs when the whole world'll be selling. Thus, value investors might seem to be inactive for long durations and they might come under severe criticism in good market conditions for their inactivity when everything is moving up.

Now, what is "Margin of Safety"? While evaluating a business/company, not everything can be deciphered about it. The future is unpredictable and also, sometimes, right questions are never asked. So, value investors take that "Margin of Safety" to compensate for the incongruencies which might creep in while going for a bargain. Now, this is a conventional definition of "Margin of Safety". Old time value investors act only by this way. For them everything is related to value in terms of number. But with the evolution of time, businesses have been able to create brands which have the properties of brand recall as well as trade barrier. The acquisitions of brands at valued prices can also be considered as "Margin of Safety". Well, there can be various notions about "Margin of Safety" depending upon individuals.

Overall, I wish to suggest that in good times, its very difficult to invest into companies based upon "Value Investment" methodologies. Only in economic downturns, it'll be possible to find value bargains without ignoring the quality of businesses.