Author: Seth Klarman
Title: Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor (Buy the Book)
The Margin of Safety was written relatively early in the career of Baupost founder, Seth Klarman, and is a basic primer on the craft of value investing. Written in 1991, the book has become a highly desired script for its relative simplicity, for its limited printing, and due to the success of its author.
According to Klarman, any form of investing that does not rely primarily on value investing precepts is both a speculation and unreliable. Value investors reject essentially all of the precepts of the Efficient Market Hypothesis, concluding instead that various securities are regularly mispriced, risk is controlled through buying companies at prices that create significant margins of safety (and not via short-term price volatility) and by hedging, and that investors are more likely to over diversify than to under diversify. They are also more willing to hold cash. As a result, they focus more on achieving a consistent absolute (positive) return than on achieving a return relative to any specific market index.
They do accept that the creation of excess risk-adjusted returns is “
Value investors generally consider Wall Street research and involvement detrimental to the production of long-term investment success. They also seek to avoid the “institutional imperatives” of self-imposed limits on flexibility such as staying fully invested, managing against a passive index, or avoiding small or complex securities. Instead, the prerequisites for true value investors are to avoid losses, target risk rather than investment performance, be willing to exert the effort for deep proprietary research, and to remain emotionally stable in comparison to other market participants whose emotional perspective often varies widely. Famously, “Mr. Market” has a continual problem remaining calm.
According to Klarman, the characteristics of professional value investors include:
- considering “real risks” to return and
focusingon loss avoidance
- using a disciplined approach to discover securities selling for a price well below the underlying value of the business
- not following market trends or fads
- periodically experiencing horrible losses – patiently waiting for the “fat pitch”
- understanding that business values do not remain constant due to cycles related to credit, deflation and/or inflation
- stressing the need for an identifiable catalyst
- requiring a margin of safety and remaining flexible and/or in their circle of competence
- understanding that valuing a company perfectly is not possible and therefore relying on multiple methods, the use of conservative assumptions, the acquisition of securities with enough margin of safety to accommodate both imprecision, valuation errors and other negative surprises, and
a minimizationof forecasting – ignoring the Efficient Market Hypothesis (EMH)
According to Klarman, there are three basic methods for security valuation, and all are flawed and imprecise. The three methods are Net Present Value (NPV or “going concern”) where the valuation associated with future growth is likely to prove too high; Liquidation Value which is a worst-case scenario, and Comparable Companies (similar ratios and multiples) which Klarman views as the least preferred method. As indicated above, using all three methods together, but weighing the results from each method differently, is generally
Finally, where do you look to identify prospective investment candidates? Klarman suggests that you develop potential investment ideas via basic value screens, reviewing the list of worst performing securities, looking at insider trading, complex securities, spin-offs, liquidations, corporate restructurings, etc. He also reminds potential investors that 80% of the value of analysis comes from the right 20% effort and if that initial analysis is fairly inconclusive, then the remaining 80% is not likely to prove useful. He also stresses the need for an identified catalyst that will unlock the true value of the investment.
Value investing is just one of many strategies that investors can apply when they participate in the stock market. In Margin of Safety, Seth Klarman intends to prove to his readers that value investing is the only approach that is logical and that it has a long history of success while other strategies frequently fail. “Once one adopts the art of value investing,” Klarman says, “all other strategies start to seem like gambling.” The first section of the book identifies the many pitfalls that investors face in the stock market.
By pointing out strategies that fail, investors can avoid the mistakes of others, which is the first step in achieving investment success. The remainder of the book focuses on the value investing approach. The book discusses the philosophy and logic behind this strategy and attempts to demonstrate why it works more successfully than other strategies. This book does not expose a secret formula to ensure investment success, but rather it provides a blueprint that offers a realistic possibility of success with limited downside risk.
Part One: Where Most Investors Stumble
“There are two times in a man’s life when he should not speculate: when he can’t afford it, and when he can.” – Mark Twain
Understanding the difference between speculating and investing in the market is the first step in achieving investment success. A speculator makes buying and selling decisions based on his opinion of where the stock market will go next. Speculators do not study fundamentals or underlying business values; instead, they view securities as pieces of paper to swap back and forth based on the actions of others.
Speculation is a “greater-fool game” where one buys an over-valued security and hopes to find someone, a greater fool, to buy it for an even higher price.
A good example of speculation is the market craze in sardine trading when the sardines disappeared from their traditional waters in Monterey, California.
The commodity traders bid them up, and the price of a can of sardines soared. One day a buyer decided to treat himself to an expensive meal and opened a can to start eating. He immediately became ill and told the seller the sardines were no good. The seller said, “You don’t understand. These are not eating sardines, they are trading sardines.” Speculators who never stop to taste the sardines they trade fuel market crazes and promote overvalued prices.
Investors, on the other hand, purchase shares of a company with sound and valid reasoning. They believe that over the long run, security prices tend to reflect fundamental developments involving the underlying business. There are three ways to realize profit: dividends, an increase in the price multiple investors are willing to pay for the stock, or convergence of stock price and underlying business value.
Value investors spend a great deal of time analyzing and studying the fundamentals of the company before making an investment decision. In addition, value investors remain emotionless and use the greed and fear of others in the market to find opportunities. Mr. Market is an imaginary investor representing the market that will buy or sell shares, on any given day, based on his mood. Investors recognize that Mr. Market knows nothing more than they do, but simply quotes assets at different prices every day. This can create opportunities for investors. They should take advantage of securities that Mr. Market has irrationally priced lower than their true business value.
Investors must not ignore the market and its volatility, but cannot let it direct them. Value in relation to price, not price alone, must guide decisions. A typical shopper will read numerous consumer publications and visit several stores before purchasing a stereo, yet many people easily invest their hard-earned money in the stock market in a matter of minutes. The buyer should apply the same rationality used when purchasing electronic equipment to buying a stock.
Participating in the stock market is not a zero-sum game; it is a negative-sum game.
Commissions and fees take money away from the market participants. Wall Street is structured to make money for itself and not for its clients. Investors should not be angry with Wall Street, but should simply accept fees as the price to pay for competing in the stock market. There is also a conflict of interest between the broker and the client.
The broker wants the client to trade as much as possible, even if it is not in the best interest of the client. It is easy to tell that Wall Street is permanently bullish. Analysts produce more buy ratings because there are more people in the “looking to buy” category than there are in the “looking to sell” category. It is also easier to initiate a buy order than to convince an investor holding the stock to sell. Encouraging people to buy also generates more commissions.
When the market goes up, everyone is happy. Investors are making money, brokers are earning commissions, and even regulators have less disgruntled investors to pacify. Rules, such as downside circuit breakers and short-sell regulations, favor bull markets as well. Investors must recognize these hidden agendas of the Street and be wary of security prices becoming too high due to investment fads and bubbles. Investors must accept these circumstances and must not depend on Wall Street to help them achieve investment success.
Any individual investor must be aware of the predicaments that institutional investors face. The many firms participating in the market make up the majority of all trading volume in a given day. These institutions deal with many hurdles as they try to outperform the market.
For example, most money managers do not invest their own money with their clients’ and therefore are not properly motivated to earn as much profit as they can. Window dressing refers to when managers buy hot stocks at the end of a quarter and sell stocks that did not perform well in order to make their quarterly statement look better than it actually was.
Institutional investors abide by self- imposed limitations that any investor must consider.
These limitations take the form of indexing, requiring to be fully invested, and tactical asset allocation. Indexing creates illusory price fluctuations, as many funds are required to buy and sell certain securities to mimic new index changes. Remaining fully invested forces buying decisions not based on sensible opportunities, but on fear of missing the market’s movements.
Paying attention to institutions in the marketplace serves two purposes. One is to remain aware of these behaviors and avoid being trampled when institutions periodically run in herds to buy or sell in the market. The other is that ample investment opportunities may exist
Investment fads, market crazes, and bubbles can have a significant impact on the overall market. The greed of investors and the self-interest of Wall Street energized the junk bond boom of the 1980s. Michael Milken of Drexel Firestone was the largest proponent of junk bonds and the main reason for their short-lived success.
Junk bonds had fallen out of favor because investors shied away from their risks. Milken started to advertise these bonds as a way to earn a high return with little risk. His argument for “little risk” incorrectly used the default rate of “fallen angel” companies from a decade earlier. This flawed assumption of a low default rate made junk bonds seem like a free lunch to investors who were hungry for yield.
Milken also promised liquidity in the bonds he traded, dispelling fears of illiquidity in that small market. However, the downfall was that the small default rate from the past did not continue into the future because the default- rate statistics were now realizing the preceding defaults. After issuance, companies did not default immediately. Their overvaluations at issuance propped them up with cash.
Even so, these securities were receiving AAA ratings based on the historical default levels. However, default in these companies was imminent and investors realized the massive delusion. When Milken first promoted junk bonds, he did not accurately portray that they provided
Valuation metrics, such as EBITDA and EBIT, do not account for the interest, taxes, depreciation, and amortization that a company needs to have on its books for future obligations. This exclusion of essential components led to considerable overvaluation and forced many investors to make bad investment decisions that incurred losses. High-yield bond mutual funds, thrifts, and insurance companies all lost billions of dollars in this investment fad.
The junk bond boom and bust
Part Two: A Value Investment Philosphy
Warren Buffett likes to say that the first rule of investing is “Don’t lose money,” and the second rule is “Never forget the first rule.”
Over the long term, stocks will outperform bonds because they have more risk, for which the market compensates investors. The effects of compounding returns from stocks are remarkable.
An investor who earns 16 percent over ten years will outperform someone who earns 20 percent in the first nine years and loses 15 percent in the tenth year.
Investors must set investment goals and be disciplined and consistent in achieving them. It is easier to target risk than to target performance because, if the actual performance a company attains is less than Wall Street’s expectations, the share price will most likely fall. Value investing is an investment strategy that considers the real risks related to the return and focuses on loss avoidance.
Searching for companies that are selling for a price that is significantly lower than the underlying value of the business is the disciplined approach called value investing. The key word to this definition is “disciplined.” Value investors often deviate from the crowd in their stock picks, do not usually follow market trends, and can experience horrible performance during some markets.
However, over the long run, value investing is so successful that few of its proponents ever abandon it. Warren Buffett describes value investing as being in the batter’s box. Remain patient, do not swing at every pitch (not even be worried by balls and strikes), and
Investors must be aware of value bargains in the market and always hold the best value opportunities that are currently available.
No holding remains off limits to sell when presented with a better opportunity. Patience is important because not all markets will present value opportunities, but sometimes there are many. Investors must remain disciplined not to swing at a bad pitch, but decide to act when they have uncovered that “sweet spot” of an investment.
Unfortunately, business values do not remain constant over time. Credit cycles and trends in inflation and deflation can cause values to change. What should an investor do about declining business values?
First, they should perform the valuation conservatively, giving high regard to worst-case scenarios. Next, investors fearing deflation should demand a higher discount to real value. In addition, asset deflation increases the importance of the timeframe of the investment. It also stresses the presence of a catalyst to realize underlying value.
Investors should not get involved in
This way, he was unlikely to experience loss. This discount provides a margin of safety, which gives investors’ analysis room for error, bad luck, mistakes, or high volatility. “Enough” room depends on how much investors can afford. If an investment is undervalued, it is equally important to ask why it is undervalued. Once the answer to this question no longer remains obvious, it is time to sell.
Declining markets provide an abundance of opportunities for value investors.
During a market downturn, value stocks do not experience excessive losses due to their already undervalued fundamentals. These stocks can fall victim to pessimistic investor confidence and have bad news already factored into the stock price. These stocks stand to benefit greatly when investor confidence turns around and investors start to pay attention to the good news and
This approach provides a large margin of safety. In any market trend, investors can hope to find much better investments outside of the market’s 100 largest stocks. Wall Street covers these stocks less often, and institutional policies can allow these stocks to fall out of favor while not concerning underlying value.
A value investor must not believe in the efficient market hypothesis. This hypothesis states that stock prices already reflect all news and there is no need for an investor to study fundamental analysis because it provides no worthwhile information. Fundamental analysis is the backbone of value investing and helps identify investment opportunities.
Value investors find opportunities by analyzing company fundamentals and finding stocks whose prices do not reflect the values of the businesses. An investor must dispel the efficient market hypothesis in order to take advantage of these differences in value.
A good example of a margin of safety is in Texaco’s debt securities in the 1980s. When Texaco ended up on the wrong side of a $10 billion legal situation, its stock and bonds plunged in price. However, Texaco’s assets appeared to cover all of its liabilities, even in the worst-case scenario.
In addition, Texaco announced all bondholders would receive the principle and all accrued interest on their bonds, but the assets refused to rise in price to their proper value. Investors who purchased these bonds when the market presented an undervalued price yielded 44%, 25%, and 19% in the next three years. Examining Texaco’s balance sheet illustrated that bondholders would be taken care of enough to represent a margin of safety in the bonds for investors.
There are three central elements to a value investment philosophy. The first is to value companies using a bottom-up approach. Next, evaluate portfolio performance in absolute terms, not relative. Lastly, pay attention to risk.
Contrary to the first element of the value investment philosophy, many investors use a top-down approach when trying to value a company. This involves surveying the macroeconomic picture, developing a theory of where it will go, determining what sectors and industries will do well, and selecting a company that should outperform. This is a risky strategy because it has plenty of room for errors.
First, the “big picture” theory must be correct in order for the sub-level assumptions to hold true.
Expectations of others must play a vital role in
A bottom-up approach is searching for bargains using fundamental analysis, one opportunity at a time. This does not involve forecasting the future of the market or the business, but rather finding a bargain in the market and waiting. The idea of value investing is for the market to realize the true value of a company over time.
Bottom-up investors do not make investments unless they are in their sweet spot and they have complete confidence in the investment. These investors know their holdings very well, they know what their risk/reward is and exactly why they are holding them. When that reason is no longer present, they will reevaluate and possibly sell. People have lost a great deal of money by holding onto an investment when the reason for which they bought is no longer valid. Top-down investors have a much more difficult time determining this reason because they must base it on macroeconomic forecasts.
The second element is evaluating performance on an absolute scale. Top-down investors assess their performance on a relative scale based on the performance of others or the market as a whole. In an investment period, if an investor lost money, yet outperformed his peers, he still lost money. This is not a loss avoidance strategy.
Relative performance does not pay and it does not preserve wealth, which is a key component of value investing. On the other hand, absolute performance investors are concerned only with achieving their investment goals, thus allowing them to remain longer-term oriented. Relative performance, on the other hand, fosters nonstop competition to be better than everyone else and leads to irrational decisions.
Looking longer-term allows an investor to hold a more sour investment for a longer time until it comes to fruition. Absolute investors also view cash as a valuable holding because it is liquid and can purchase a new opportunity at the desired moment.
No single number can determine a stock’s level of risk.
Even beta does not accurately portray risk because it does not consider the price paid for the investment. It only considers past price movements and does not account for business fundamentals or economic conditions. The long-term investor should pay attention to short-term price fluctuations because they can provide opportunities for increased return.
For example, when interest rates rise and bond prices drop, interest payments earn a higher return when reinvested at
Correctly valuing a business is nearly impossible. Business valuation is susceptible to many assumptions because future cash flows are difficult to forecast. Net present values and internal rates of return give one-stop answers to business valuations, but these models incorporate numerous assumptions and are only as accurate as the data. Only bonds can be valued this way due to their guaranteed future cash flows.
Benjamin Graham states that security analysis does not need to determine exactly the intrinsic value of a given security. It needs only to establish that the value is adequate by being considerably higher or lower than the market price. For this purpose, an approximate measure of intrinsic value is sufficient. This is the idea of a margin of safety. A large disparity between the intrinsic value and the market price of
There are three useful ways to value a business. The first is NPV, or going concern, valuation. This approach discounts all foreseeable future cash flows and works best on big conglomerates with an easily assumed discount rate and predictable cash flows. Growth rates are fragile because they have the greatest impact on the result.
Growth has many moving parts, not just one number. Consider all sources of growth, such as population growth, instead of finding one perfect growth rate. It is important to note that most analysts predict growth rates that are too high because of the optimistic bias about the future, so conservative assumptions are better.
Investors should choose a higher discount rate that reflects the preference of present cash flows over future cash flows. The market determines rates, and during periods of low rates, many investors end up paying higher prices, decreasing their margin of safety.
In addition, investors should value stocks using all of the underlying cash flows of the business, not just dividends, because dividends make up only a small percentage of the cash flows. A shortcut to this valuation is “private- market” value, which involves using multiples that a similar business sold for during private purchase deals. Due to its many flaws, this shortcut should only be one of many inputs when considering value.
Liquidation value is the second way to value a business.
This method splits a company into pieces and values each piece separately. Investors should only consider tangible balance sheet items, not intangibles. Liquidation is the worst-case scenario when a company has been losing money and has a good chance of bankruptcy. During a slow and well-organized sale, treat cash as 100 cents on the dollar, investment securities at market value (
Discounting inventory depends on the state of the inventory: finished goods, in
The last and least reliable valuation method is estimating what the company would trade for in the stock market. Only use this approach when the period for valuation is short. Compare multiples and values of similar companies in the market then adjust appropriately to fit the company of interest.
Since all of these methods use assumptions that are prone to error, the only way to justify their usefulness is to rely on conservatism. Assumptions that are more conservative lead to valuations that are more reasonable. All three methods have pros and cons, and not one produces a correct answer all the time. However, using them together can provide a reasonable valuation number.
Esco Electronics in 1990 provides a meaningful example showing how to find
However, their book value was $25 and their net-net working capital was $15. After discounting the free cash flows to present value and excluding the non-recurring charges, the stock was valued at $5.87. With a conservative estimate of $0.20/share growth for ten years, the stock was then valued at $14.76. However the valuation was constructed, all numbers were greater than the $3 market price.
Esco’s price represented disaster levels so any disappointing news could not hurt the stock much more, but good news had tremendous upside. After the first year, Esco was back up to $8. The convenient thing about this example is that investors did not have to know the exact value of Esco, but it was easy to conclude that it was more than $3. Investors who found this opportunity had
Business valuation is a complex process, more often than not yielding incorrect answers. However, there are opportunities to use these methods and find companies that do justify this approach. Investors should not swing at every pitch, only the ones that they know are in their sweet spot. Investors will have an advantage by not trying to play the game they do not know and sticking to what they do know.
Part Three: The Value Investment Process
Value investing is somewhat of a contrarian strategy. Investors must be confident enough in their analysis to go against the market and commit to investing in a company that they believe the market is undervaluing. Most likely, value investors are wrong at first, and maybe for a while, until the price reflects the true valuation. Yet remember, Keynes said it best, “The market can remain irrational longer than you can remain solvent.”
Hard work and discipline are the only ways to find good investment ideas.
They do not come from a single answer or solution. Computer screening is useful when looking for companies trading at discounts, but investors need to perform additional research to verify the quality of the results. Basic ideas can come from the “worst performers” section of the Wall Street Journal to find stocks that traders are shunning.
Companies whose managers, especially executives, are purchasing stock in the company with their own resources show
Management then focuses on stock price and tries to narrow the gap between market price and true value. Opportunities arise in companies that institutions are not involved in and therefore have inefficient prices. Discover value not in what the herd is buying, but what they are selling or ignoring. Once investors find a bargain, the next step is determining why that bargain is available.
If someone was buying a house that was for sale at half its market value, he must ask, “What is wrong with it?” Once investors determine the reason for the undervaluation, this unfolds more certainty because the outcome is more predictable.
If investors study all news, financial reports, and analyst research papers, there would be no time to capitalize on opportunities and invest.
Investors cannot spend time trying to understand every aspect and detail of a company that is a potential investment. Exact certainty of details in a company does not take priority over a perfect buy-in moment.
An investor will never understand it all, and if he does, it will most likely become irrelevant in the time it takes him to obtain the knowledge. There is a common principle with information, 80/20; you will learn 80% of the information in the first 20% of time spent. Additional time spent learning leads to diminishing returns.
Value investors look to own securities with catalysts, which are unexpected market announcements or sudden increases in stock price. Realization of value from a catalyst is an important means of generating profits because it tightens the margin of safety. Catalysts that provide total value realization are optimal.
Complex securities, those that do not present usual cash flow characteristics, can provide opportunity for value investors with attractive returns and a set amount of risk. Railroad income bonds, preferred stock, and rights offerings are all examples of complex securities because most investors lack the ability to value such investments, which value investors can find as an opportunity.
Spinoffs, liquidation, and corporate restructurings fall into the category of risk arbitrage where the profitability depends more on the outcome of the transaction than the company’s fundamentals. Investors with large portfolios and vast resources have the advantage because they can employ the brightest lawyers and agents to find the most accurate and recent information regarding the transaction.
Spinoffs can create temporary moments of opportunity with depressed share prices because many people are selling. When shareholders receive these subsidiary shares, they sell because they do not know much about them. Institutional investors sell because it is too small of a position to spend time on.
Index funds also sell because the new shares are not included in their index. These depressed prices do not exist because the sellers know more than the buyers do; it is because they know much less. This provides support that the market is sometimes inefficient, and investors willing to look for bargains can find them.
Financially distressed and bankrupt securities can offer occasional investments, but they come with considerable uncertainty.
Investors, who are willing to be patient, analyze, and take on uncertainty can find favorable risk/reward opportunities. When companies get into financial trouble, there are three options they have: continue to pay interest and principles on debt, exchange old debt for new securities (most often of lower value), or default and file for bankruptcy.
Involved parties most prefer the first option, supported by
Prepackaging a plan of reorganization that states what the majority of investors will do lets investors act accordingly if bankruptcy does occur. Bankruptcy is the third and worst option, and companies try to avoid it at all costs because of the negative stigma it carries. Cash will build up significantly due to the lack of payments on interest and principle,
Bankruptcy can be a catalyst to realizing underlying value when the company emerges leaner and simpler, and analysts study the business to understand the new value.
The first stage of bankruptcy, immediately after the filing of
The third stage is the most certain stage of the process, and it is the time between when the reorganization plan is settled and when the company finally emerges. Investments initiated at stages with more uncertainty have the potential to yield greater profits. However, the
In order to invest in these companies, one must value both sides of the balance sheet. It is very difficult to value companies that are going through bankruptcy because their value is a moving target, not known by any party. These businesses are very unstable, exacerbated by irregular cash flows and income statement anomalies, such as legal and investment banking charges. The bond and equity markets may tell two different stories.
This can present opportunities to lock in valuation differences and profit from distressed bond prices or opportunistic equity prices. These strategies of investing in bankrupt or troubled securities
Investing is a never-ending process.
Each investment can have a start and end, but the act of investing and portfolio management is a continual process. Investors must find a balance of liquidity to have an optimal portfolio. An extremely liquid portfolio, one that is mostly in cash, does not yield high returns. Yet, a highly illiquid portfolio must compensate enough for the illiquidity.
Venture capital investments are high duration, illiquid investments with large payoffs that compensate investors for the long time of illiquidity. Diversification and hedging are effective portfolio risk-management tools. Diversification is best when holding 10 to 15 securities, and over-diversification is prohibitive to a successful and risk-averse portfolio.
Owning fewer securities that an investor is more confident about and knows more intimately can yield higher returns. The importance of diversification is not how many securities are held but how different are the holdings’ risks. Hedging is another way to reduce market risk. Selling S&P index futures on a diversified large-cap portfolio will eliminate changes in the market and leave only individual security returns. All investors must stay in touch with the market.
The method of buying, holding, and not looking back for many years is no longer a sure-fire strategy. However, being too close to the market can have implications, such as being swayed into emotional trading or giving into the crowds, even when it goes against an investor’s judgment. It is important that investors remain rational when reacting to price movements. Selling is the hardest decision of all, and it should only depend on other opportunities available. Holding out for a few extra basis points of profit when there are other promising opportunities is foolish.
Mutual funds are an attractive alternative to investors who cannot devote the time to all of the responsibilities that value investing requires.
They provide reasonable diversification, low fees, and professional management. Choose a no-load, open-ended fund that trades near its NAV. Finding the right money manager includes understanding precisely what they do, evaluating their investment strategy, and ensuring their integrity. The right money manager must also have impressive investment results and absolute returns that are consistent with low risk.
Any investment approach beyond owning U.S. T-bills will carry some risk. Investors should consider their investment needs and the time spent accumulating their wealth, then decide if they want to earn the risk-free return on their assets, the average return by owning index funds, or if they desire more than that. Maintaining a value investment philosophy and committing the time to this goal will help them to preserve and increase their wealth.
Britt always taught us
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