Margin of Safety

Seth A. Klarman wrote the book, Margin of Safety. You can buy your own copy on Amazon. It is currently available for $2,999.97. Or you could just read my summary of key lessons I learned from reading it. He outlines risk-averse value investing strategies for the thoughtful investor.

Seth Klarman is an American billionaire investor and author. He is the portfolio manager of the Baupost Group ($30 billion in assets), a private investment partnership. Benjamin Graham profoundly influenced his investment philosophy. He is known for buying unpopular assets while they are undervalued. Klarman seeks a margin of safety and profits from any price rise. Since his fund’s start in 1982, he has realized a 20% compounded return on investment.

Where Most Investors Stumble

Is it credible that the value of American industry in the aggregate declined by 23% on a single day, October 19, 1987? Remember, stocks are fractional ownership of the underlying businesses. His approach is to determine the value of underlying security and buy at a discount from that value.

Investors focus too much on reward and pay little attention to risk. Consider how much you can lose. Value investors have a primary goal of preserving capital. Value investors seek a margin of safety.

The most beneficial time to be a value investor is when the market falls. The booming bull has supported growth over value. That doesn’t mean it will continue.

Speculators & Unsuccessful Investors

“There are two times a man should not speculate: when he can’t afford it and when he can.”  Mark Twain

Investors look for free cash flow that will enrich the investor. Over time, the gap between price and business value will narrow.

Speculators buy securities based on a prediction that the price will rise. Speculators are guessing the direction of stock prices. In reality, no one knows what the market will do; trying to predict it is a waste of time. Investing based on that prediction is a speculative undertaking.

Speculators are likely to lose money over time. Unsuccessful investors are dominated by emotion. They respond to greed and fear. After minimal research, people commonly make decisions based on comments from friends. Speculators mistakenly look to Mr. Market for investment guidance.

Speculation offers the prospect of instant gratification. Speculators want to find a buyer at a higher price – hoping for a greater fool.

Pay attention to macroeconomics. A decline in interest rates generally increases security prices.

Value investors pay attention to financial reality. Investments throw off cash flow for the benefit of the owners; speculations do not.

Wall Street Versus Investors

What is good for Wall Street is not necessarily suitable for investors. Wall Street is plagued by conflicts of interest and a short-term orientation. Wall Street gets paid primarily for what they do, not how effectively they do it. While investors might be best off owning U.S. Treasury bills and no-load mutual funds, brokers are motivated to sell high-commission securities. The firm and the customer are often opposite sides of a zero-sum game.

Be aware of the motivations of people who transact business through transactions. Wall Street takes advantage of the gullibility of the buyers. Wall Street has an up-front fee orientation. That ensures they always get paid. Many transactions are geared toward short-term maximization of income as the primary goal. Wall Street has a strong bullish bias. They encourage clients to buy more than sell. This is often at odds with the best interest of the client.

Be wary of new tools on Wall Street. Financial market innovations are good for Wall Street but bad for clients. Wall Street is never satisfied with its success. There will always be something new. But remember that all market fads come to an end.

Prices become too high. Supply catches up and then exceeds demand. The top is reached. Then, the downward slide ensues. There will always be cycles of investment fashion. Wall Street can be a dangerous place for investors. Be on your guard. Wall Street tends to maximize self-interest.

Clients Lose

Institutional investors are plagued with a short-term orientation.

Investing used to be dominated by stocks, government bonds, and high-grade corporate bonds. Memories of the 1929 stock crash lingered. Professional money managers acted as fiduciaries and were held to a “prudent man” standard.

Those days are gone. More common now are groupthink, mediocrity, underperformance, and short-term thinking. The short-term focus is especially dangerous since short-term fluctuations are random. Making changes based on random noise only increases transaction costs and reduces client value.

Money managers don’t always invest in what they recommend to clients. Would you trust a chef who doesn’t eat their cooking? They should be required to have skin in the game, much like Roman engineers who were required to stand beneath the arches they built.

Money managers spend time on sales, marketing, client meetings, and hand-holding rather than studying annual reports and financial periodicals.

Managers rarely make unconventional investments since the cost of being wrong is too high. As a result, they make common investments and still extract a fee for those mediocre investments.

Investing Too Late

By the time a fund is known to have an outstanding track record, it is too late. The return per dollar invested declines as total assets increase. Investors enter too late and receive minimal benefits or losses before abandoning the fund after declines.

Too many investors attempt to avoid downside risk. They search for “portfolio insurance,” which allows upside gains but eliminates downside risk. Arbitrageurs buy futures and sell stocks when trading outside a narrow range. The problem is the market does not always rise and fall orderly. October 19, 1987 should have ended any quest for portfolio insurance.

Seth Klarman acknowledges the trend towards low-cost index investing. He feels knowledgeable value investors will still be able to outperform the passive index. He notes deviations between value and price as opportunities for those who take advantage.

Delusions of Value

Klarman feels the junk bond boom of the 1980s illustrates delusions of value. Greed and ignorance combined with short-term orientation formed a toxic mix of speculation. Junk bonds were seriously flawed by high default rates. Leverage was applied.

Once risks became apparent, prices plunged. Newly issued junk bonds were not the low-risk instruments that buyers were led to believe. They offered no margin of safety. They provided limited appreciation with substantial downside risk.

The bonds were sold by an army of Michael Milken’s sales force. The companies were analyzed using EBITDA, which is a flawed accounting tool. It ignores expenses such as depreciation. Real cash will be required when factory equipment wears out and needs to be replaced.

Depreciation is a valid expense and needs to be accounted for. Junk bonds were a poor investment and allowed the loss of one’s entire investment. The market finally collapsed in 1990, and the truth became apparent.

A Value-investment Philosophy

Investment Goals

“The first rule of investing is ‘Don’t lose money.’

The second rule is, ‘Never forget the first rule.'”  Warren Buffett

Klarman also believes avoiding loss should be the primary goal of every investor. Over several years, an investment portfolio should not be exposed to appreciable loss of principal.

We must resist the speculative urge. That urge is vital since we find a free lunch compelling. Still, we must concentrate on potential losses. Avoiding losses is the surest way to ensure a profitable outcome. Loss-avoidance strategy is at odds with conventional market wisdom. That’s why it isn’t easy to do.

Equities are inherently riskier than debt. The equity receives the residual after all liabilities are satisfied. The actual risk can’t be determined from historical data.

The future is unpredictable. No one knows whether the economy will shrink or grow, the inflation rate, and whether interest rates and share prices will rise or fall. Financial catastrophes can and do occur. How can you prepare for worst-case scenarios?

Risk avoidance is the most critical element of an investment program. Loss avoidance must be the cornerstone of your investment philosophy.

It is difficult to recover from even one significant loss. Losses prevent the benefit of compounded gains over a long time. To achieve consistently good returns, you must limit downside risk.

An investor who earns 16% annually for a decade will have more money than an investor who earns 20% per year for nine years and then loses 15% in the tenth year.

Be disciplined in your approach. In the long run, stock prices align with the performance of the underlying business.

Rather than targeting a desired rate of return, investors should target risk. T-bills are riskless. Invest in other options; only consider higher returns without additional risk.

Value Investing

Value investing is the discipline of buying securities at a significant discount from their underlying values and holding them until more of their value is realized.

The ideal is buying a dollar for fifty cents. Value investing combines the conservative analysis of underlying value with the requisite discipline and patience to buy only when a sufficient discount is available. This requires discipline. And it can be a lonely route.

It would be best if you considered market valuations. The cheapest security in an overvalued market may still be overvalued. Don’t feel compelled to jump at every suitable opportunity. There are no called strikes. Avoid swinging at bad pitches.

Observe the business cycle. Volatility in business value fluctuates with the credit cycle.

Demand a margin of safety. Buying a dollar of value for a dollar provides no margin of safety. Most investors don’t insist on a margin of safety. They have a margin of peril.

“When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And that same principle works in investing.” Warren Buffett

Fundamental Analysis

When reviewing the balance sheet, pay attention to tangible assets. They are more precisely valued than intangibles. They allow more significant protection from loss. Consider the liquidation value of the business as a worst-case scenario. Always buy at a discount to the underlying business value – emphasizing tangible assets.

A notable feature of value investing is its strong performance in periods of overall market decline. Some stocks even sell below net working capital per share. Such a discount to book value provides a margin of safety in down markets.

Since the weak form of the efficient-market hypothesis is valid, technical analysis wastes time. Stock prices provide no helpful information on the future direction of stock prices.

Large-cap stocks tend to be more efficient than small-capitalization stocks. Small companies have fewer analysts. Therefore, there is more opportunity for security analysis in smaller companies.

Value investing is a method of arbitrage between security prices and underlying business value. Investing is not risk-free; profits are neither instantaneous nor specific. Value investing is simple to understand but challenging to implement.

The hard part is discipline, patience, and judgment. It would help if you had the patience to wait for the right pitch and the judgment to know when it is time to swing.

Investment Philosophy

Value investing involves a bottom-up strategy of finding undervalued investment opportunities. The focus should be on absolute performance rather than relative. It is a risk-averse approach that focuses as much on what could go wrong as what could go right.

We should set an asset price above which we will not pay. That price is based on fundamental analysis. We should hold cash until we find a bargain. Then buy cheap and wait. We can sell our holdings when they are fully valued. We should prefer out-of-favor holdings since they have less risk of loss.

Don’t worry about “cash drag.” Cash carries no risk. It does not drop in value during market declines.

Many mistakenly equate risk with volatility. Risk is the permanent loss of value needed to meet a goal. Return and risk must be evaluated separately. Risk cannot be reduced to a single number, such as the standard deviation of stock price. Volatility does not predict future investment performance and is, therefore, a poor measure of risk.

You shouldn’t invest if you can’t tolerate some volatility. A fluctuating price doesn’t always mean a permanent loss of capital. Price can deviate from value in the short term.

A dollar spent on biotechnology research is riskier than a dollar used to purchase utility equipment. The former has a greater probability of loss.

We can diversify, hedge, and insist on a margin of safety to reduce risks.

Art of Valuation

Business value is imprecisely knowable. The exact numbers obtained by calculations such as IRR and NPV give the investor a false sense of certainty. They are only as accurate as the cash flow assumptions used to derive them. Using a computer won’t help. GIGO. Garbage in, garbage out.

Businesses, unlike debt instruments, do not have contractual cash flows. As a result, they can’t be precisely valued. At best, we can come up with a range of expected values. They will fluctuate and conform to the intrinsic value.

At the bottom, we can look at the liquidation value. The net working capital per share is an excellent back-of-the-envelope estimate. So, the liquidation value is one number to look at. Then, look at the share price on the market for another opinion.

A third value can be obtained by estimating the NPV. NPV is the discounted value of all future cash flows the business is expected to generate. Unfortunately, the future isn’t perfectly predictable. That’s why we need a range and a margin of safety. Conservative forecasts of future cash flow are a crucial ingredient to success.

Beware of Assumptions

Changing your discount rate can affect the intrinsic value substantially. There is no single correct value. Some use 10%. It isn’t a flawed approach, but it isn’t always optimal. Others use the rate of short-term Treasuries or low-grade bonds. Assess the impact of different discount rates to understand the range. This is a form of a sensitivity analysis.

Another value approach is to pretend you are buying the entire company on the private market. Would you pay a multiple, say eight to ten times free cash flow? The actual value may be between this value and the liquidation value.

Benjamin Graham calculated net-net working capital. Net working capital is current assets minus current liabilities. Net-net working capital is net working capital minus all long-term liabilities. Investors who buy below net-net working capital are protected from loss.

Value-investment Research Process

Where to look for opportunities? Computer screens can help. Search for low price-to-book value and low price-to-earnings ratios. Read about distressed and bankrupt businesses. Look for stocks reaching all-new lows for the year.

Think like a contrarian. Deep values are not likely to be found where a large mass of people is looking. Avoid popular growth fads. Look for solid companies who came into some damaging press. Investors often overreact to bad news.

If the company remains fundamentally sound, that could spell an opportunity. Look for corporate insider investing. Look for companies that are repurchasing their own shares. Those leaders feel the market undervalues the stock. After the initial screen, dig into the financials. Investment research involves distilling the investment wheat from the chaff.

Here’s to your fruitful search for value investment gems!