Margin of Safety by Seth Klarman

My Score – 8/10

A good book for those who don’t quite understand value investing, otherwise it’s pretty dry.

Note: we live in a world where investing books are supposed to be entertaining. Strange, isn’t it?

My favorite highlights are below, along with some other notes.

Contents

Seth covers a lot of ground, and very thoroughly. If you’re like me then this table of contents gets you excited.

Main Takeaways:

  • Value investing works as long as humans drive the market.
  • Buying a slice of a business for less than it’s worth is the surest way to investing success.
  • Still, most investors, large and small, succumb to foolish tactics which invariably hinder performance.

Pros

  • Explains the thought process behind value investing and the attraction to smaller companies for smaller investors.

  • Inside look into how Seth thinks, which is extremely valuable on its own.

Cons

  • Dry. Like DRY dry.

  • One of the tactics suggested for finding investing ideas is to sign up for blogs or newsletters. 🙄 (To his credit, I don’t think he knew blogs and newsletters would be this big in the investing space in 2022)

Favorite Quote

Individual and institutional investors alike frequently demonstrate an inability to make long-term investment decisions based on business fundamentals. There are a number of reasons for this: among them the performance pressures faced by institutional investors, the compensation structure of Wall Street, and the frenzied atmosphere of the financial markets. As a result, investors, particularly institutional investors, become enmeshed in a short-term relative performance derby, whereby temporary price fluctuations become the dominant focus. Relative performance-oriented investors, already focused on short-term returns, frequently are attracted to the latest market fads as a source of superior relative performance. The temptation of making a fast buck is great, and many investors find it difficult to fight the crowd.

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Highlights

All below is from the book. My words italicized. Bold and highlights mine.

Introduction

Avoiding where others go wrong is an important step in achieving investment success. In fact, it almost ensures it.Individual and institutional investors alike frequently demonstrate an inability to make long-term investment decisions based on business fundamentals. There are a number of reasons for this: among them the performance pressures faced by institutional investors, the compensation structure of Wall Street, and the frenzied atmosphere of the financial markets. As a result, investors, particularly institutional investors, become enmeshed in a short-term relative performance derby, whereby temporary price fluctuations become the dominant focus. Relative performance-oriented investors, already focused on short-term returns, frequently are attracted to the latest market fads as a source of superior relative performance. The temptation of making a fast buck is great, and many investors find it difficult to fight the crowd.

Those who can predict the future should participate fully, indeed on margin using borrowed money, when the market is about to rise and get out of the market before it declines. Unfortunately, many more investors claim the ability to foresee the market’s direction than actually possess that ability. (I myself have not met a single one.) Those of us who know that we cannot accurately forecast security prices are well advised to consider value investing, a safe and successful strategy in all investment environments.

I find value investing to be a stimulating, intellectually challenging, ever changing, and financially rewarding discipline. I hope you invest the time to understand why I find it so in the pages that follow.

Part 1: Where Most Investors Stumble

Speculators and Unsuccessful Investors

Investors in a stock thus expect to profit in at least one of three possible ways: from free cash flow generated by the underlying business, which eventually will be reflected in a higher share price or distributed as dividends; from an increase in the multiple that investors are willing to pay for the underlying business as reflected in a higher share price; or by a narrowing of the gap between share price and underlying business value. Speculators, by contrast, buy and sell securities based on whether they believe those securities will next rise or fall in price. Their judgment regarding future price movements is based, not on fundamentals, but on a prediction of the behavior of others.

Speculators are obsessed with predicting—guessing—the direction of stock prices. Every morning on cable television, every afternoon on the stock market report, every weekend in Barron’s, every week in dozens of market newsletters, and whenever businesspeople get together, there is rampant conjecture on where the market is heading. Many speculators attempt to predict the market direction by using technical analysis—past stock price fluctuations—as a guide. Technical analysis is based on the presumption that past share price meanderings, rather than underlying business value, hold the key to future stock prices. In reality, no one knows what the market will do; trying to predict it is a waste of time, and investing based upon that prediction is a speculative undertaking.

Today many financial-market participants, knowingly or unknowingly, have become speculators. They may not even realize that they are playing a “greater-fool game,” buying overvalued securities and expecting—hoping—to find someone, a greater fool, to buy from them at a still higher price.

Just as financial-market participants can be divided into two groups, investors and speculators, assets and securities can often be characterized as either investments or speculations. The distinction is not clear to most people. Both investments and speculations can be bought and sold. Both typically fluctuate in price and can thus appear to generate investment returns. But there is one critical difference: investments throw off cash flow for the benefit of the owners; speculations do not.4 They return to the owners of speculations depends exclusively on the vagaries of the resale market.

The apparent value of collectibles is based on circular reasoning: people buy because others have recently bought. This has the effect of bidding up prices, which attracts publicity and creates the illusion of attractive returns. Such logic can fail at any time.

The Differences between Successful and Unsuccessful Investors

Emotional investors and speculators inevitably lose money; investors who take advantage of Mr. Market’s periodic irrationality, by contrast, have a good chance of enjoying longterm success.

when the price of a stock declines after its initial purchase, most investors, somewhat naturally, become concerned. They start to worry that Mr. Market may know more than they do or that their original assessment was in error. It is easy to panic and sell at just the wrong time. Yet if the security were truly a bargain when it was purchased, the rational course of action would be to take advantage of this even better bargain and buy more.

It is vitally important for investors to distinguish stock price fluctuations from underlying business reality. If the general tendency is for buying to beget more buying and selling to precipitate more selling, investors must fight the tendency to capitulate to market forces. You cannot ignore the market—ignoring a source of investment opportunities would obviously be a mistake—but you must think for yourself and not allow the market to direct you. Value in relation to price, not price alone, must determine your investment decisions. If you look to Mr. Market as a creator of investment opportunities (where price departs from underlying value), you have the makings of a value investor. If you insist on looking to Mr. Market for investment guidance, however, you are probably best advised to hire someone else to manage your money.

Unsuccessful investors are dominated by emotion.

Just as many generals persist in fighting the last war, most investment formulas project the recent past into the future.

You probably would not choose to dine at a restaurant whose chef always ate elsewhere. You should be no more satisfied with a money manager who does not eat his or her own cooking. It is worth noting that few institutional money managers invest their own money along with their clients’ funds. The failure to do so frees these managers to singlemindedly pursue their firms’, rather than their clients’, best interests.

No single meeting places an intolerable burden on a money manager’s time; cumulatively, however, the hours diverted to marketing can take a toll on investment results.

Absolute-performance-oriented investors, by contrast, will buy only when investments meet absolute standards of value. They will choose to be fully invested only when available opportunities are both sufficient in number and compelling in attractiveness, preferring to remain less than fully invested when both conditions are not met. In investing, there are times when the best thing to do is nothing at all. Yet institutional money managers are unlikely to adopt this alternative unless most of their competitors are similarly inclined.

To value investors the concept of indexing is at best silly and at worst quite hazardous. Warren Buffett has observed that “in any sort of a contest—financial, mental or physical—it’s an enormous advantage to have opponents who have been taught that it’s useless to even try.”6 I believe that over time value investors will outperform the market and that choosing to match it is both lazy and shortsighted.

Indexing is a dangerously flawed strategy for several reasons. First, it becomes self defeating when more and more investors adopt it.

Another problem arises when one or more index stocks must be replaced; this occurs when a member of an index goes bankrupt or is acquired in a takeover.

Barron’s has calculated that stocks added to the Standard & Poor’s 500 Index outperformed the market by almost 4 percent in the first week after their inclusion.

Charges for goodwill amortization usually do represent free cash flow.

If a historically accepted investment yardstick proves to be overly restrictive, the path of least resistance is to invent a new standard.6

EBITDA Analysis Obscures the Difference between Good and Bad Businesses

perseverance at even relatively modest rates of return is of the utmost importance in compounding your net worth. A corollary to the importance of compounding is that it is very difficult to recover from even one large loss, which could literally destroy all at once the beneficial effects of many years of investment success. In other words, an investor is more likely to do well by achieving consistently good returns with limited downside risk than by achieving volatile and sometimes even spectacular gains but with considerable risk of principal. An investor who earns 16 percent annual returns over a decade, for example, will, perhaps surprisingly, end up with more money than an investor who earns 20 percent a year for nine years and then loses 15 percent the tenth year.

Investors must be willing to forego some near-term return, if necessary, as an insurance premium against unexpected and unpredictable adversity.

Many investors mistakenly establish an investment goal of achieving a specific rate of return. Setting a goal, unfortunately, does not make that return achievable. Indeed, no matter what the goal, it may be out of reach. Stating that you want to earn, say, 15 percent a year, does not tell you a thing about how to achieve it. Investment returns are not a direct function of how long or hard you work or how much you wish to earn. A ditch digger can work an hour of overtime for extra pay, and a piece worker earns more the more he or she produces. An investor cannot decide to think harder or put in overtime in order to achieve a higher return. All an investor can do is follow a consistently disciplined and rigorous approach; over time the returns will come.

Moreover, while the value of a stock is ultimately tied to the performance of the underlying business, the potential profit from owning a stock is much more ambiguous. Specifically, the owner of a stock does not receive the cash flows from a business; he or she profits from appreciation in the share price, presumably as the market incorporates fundamental business developments into that price. Investors thus tend to predict their returns from investing in equities by predicting future stock prices. Since stock prices do not appreciate in a predictable fashion but fluctuate unevenly over time, almost any forecast can be made and justified. It is thus possible to predict the achievement of any desired level of return simply by fiddling with one’s estimate of future share prices.

Value investing is the discipline of buying securities at a significant discount from their current underlying values and holding them until more of their value is realized. The element of a bargain is the key to the process. In the language of value investors, this is referred to as 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 from that value is available. The number of available bargains varies, and the gap between the price and value of any given security can be very narrow or extremely wide. Sometimes a value investor will review in depth a great many potential investments without finding a single one that is sufficiently attractive. Such persistence is necessary, however, since value is often well hidden.

The disciplined pursuit of bargains makes value investing very much a risk-averse approach. The greatest challenge for 99 value investors is maintaining the required discipline. Being a value investor usually means standing apart from the crowd, challenging conventional wisdom, and opposing the prevailing investment winds. It can be a very lonely undertaking. A value investor may experience poor, even horrendous, performance compared with that of other investors or the market as a whole during prolonged periods of market overvaluation. Yet over the long run the value approach works so successfully that few, if any, advocates of the philosophy ever abandon it.

Warren Buffett uses a baseball analogy to articulate the discipline of value investors. A long-term-oriented value investor is a batter in a game where no balls or strikes are called, allowing dozens, even hundreds, of pitches to go by, including many at which other batters would swing. Value investors are students of the game; they learn from every pitch, those at which they swing and those they let pass by. They are not influenced by the way others are performing; they are motivated only by their own results. They have infinite patience and are willing to wait until they are thrown a pitch they can handle—an undervalued investment opportunity.

Most institutional investors, unlike value investors, feel compelled to be fully invested at all times. They act as if an umpire were calling balls and strikes—mostly strikes—thereby forcing them to swing at almost every pitch and forego batting selectivity for frequency. Many individual investors, like amateur ballplayers, simply can’t distinguish a good pitch from a wild one. Both undiscriminating individuals and constrained institutional investors can take solace from knowing that most market participants feel compelled to swing just as frequently as they do.

no investment should be considered sacred when a better one comes along.

It would be a serious mistake to think that all the facts that describe a particular investment are or could be known. Not only may questions remain unanswered; all the right questions may not even have been asked. Even if the present could somehow be perfectly understood, most investments are dependent on outcomes that cannot be accurately foreseen. Even if everything could be known about an investment, the complicating reality is that business values are not carved in stone. Investing would be much simpler if business values did remain constant while stock prices revolved predictably around them like the planets around the sun. If you cannot be certain of value, after all, then how can you be certain that you are buying at a discount? The truth is that you cannot.

Benjamin Graham understood that an asset or business worth $1 today could be worth 75 cents or $1.25 in the near future. He also understood that he might even be wrong about today’s value. Therefore Graham had no interest in paying $1 for $1 of value. There was no advantage in doing so, and losses could result. Graham was only interested in buying at a substantial discount from underlying value. By investing at a discount, he knew that he was unlikely to experience losses. The discount provided a margin of safety.

A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable, and rapidly changing world.

Buffett described the margin of safety concept in terms of tol erances: “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.”2

What is the requisite margin of safety for an investor? The answer can vary from one investor to the next. How much bad luck are you willing and able to tolerate? How much volatility in business values can you absorb? What is your tolerance for error? It comes down to how much you can afford to lose.

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.

When the overall market is strong, the rising tide lifts most ships. Profitable investments are easy to come by, mistakes are not costly, and high risks seem to pay off, making them seem reasonable in retrospect. As the saying goes, “You can’t tell who’s swimming naked till the tide goes out.”

A market downturn is the true test of an investment philosophy. Securities that have performed well in a strong market are usually those for which investors have had the highest expectations. When these expectations are not realized, the securities, which typically have no margin of safety, can plummet.

The securities owned by value investors are not buoyed by such high expectations. To the contrary, they are usually unheralded or just ignored. In depressed financial markets, it is said, some securities are so out of favor that you cannot give them away. Some stocks sell below net working capital per share, and a few sell at less than net cash (cash on hand less all debt) per share; many stocks trade at an unusually low multiple of current earnings and cash flow and at a significant discount to book value.

Investors should understand not only what value investing is but also why it is a successful investment philosophy. At the very core of its success is the recurrent mispricing of securities in the marketplace. Value investing is, in effect, predicated on the proposition that the efficientmarket hypothesis is frequently wrong.

Specifically, by finding securities whose prices depart appreciably from underlying value, investors can frequently achieve above-average returns while taking below-average risks.

Is it reasonable to expect that in the future some securities will continue to be significantly mispriced from time to time? I believe it is. The elegance of the efficient-market theory is at odds with the reality of how the financial markets operate.

Benjamin Graham and David Dodd explained stock mispric-ings this way: “The market is not a weighing machine, on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities.. .The market is a voting machine, whereon countless individuals register choices which are the product partly of reason and partly of emotion.”

Like hope, greed, and fear.

The long-term expectation, however, is for the prices of securities to move toward underlying value.

Value investing is simple to understand but difficult to implement. Value investors are not supersophisticated analytical wizards who create and apply intricate computer models to find attractive opportunities or assess underlying value. The hard part is discipline, patience, and judgment. Investors need disci pline to avoid the many unattractive pitches that are thrown, patience to wait for the right pitch, and judgment to know when it is time to swing.

To the extent that most investors think about risk at all, they seem confused about it. Some insist that risk and return are always positively correlated; the greater the risk, the greater the return. This is, in fact, a basic tenet of the capital-asset-pricing model taught in nearly all business schools, yet it is not always true. Others mistakenly equate risk with volatility, emphasizing the “risk” of security price fluctuations while ignoring the risk of making overpriced, ill-conceived, or poorly managed investments.

Since the financial markets are inefficient a good deal of the time, investors cannot simply select a level of risk and be confident that it will be reflected in the accompanying returns. Risk and return must instead be assessed independently for every investment.

You cannot appraise the value of your home to the nearest thousand dollars. Why would it be any easier to place a value on vast and complex businesses?

Typically, investors place a great deal of importance on the output, even though they pay little attention to the assumptions. “Garbage in, garbage out” is an apt description of the process.

The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security. It needs only to establish that the value is adequate—e.g., to protect a bond or to justify a stock purchase—or else that the value is considerably higher or considerably lower than the market price. For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient.1

While a great many methods of business valuation exist, there are only three that I find useful. The first is an analysis of going-concern value, known as net present value (NPV) analysis. NPV is the discounted value of all future cash flows that a business is expected to generate.

As Warren Buffett has said, “For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments.”5

Investors are well advised to make only conservative projections and then invest only at a substantial discount from the valuations derived therefrom.

The other component of present-value analysis, choosing a discount rate, is rarely given sufficient consideration by investors. A discount rate is, in effect, the rate of interest that would make an investor indifferent between present and future dollars. Investors with a strong preference for present over future consumption or with a preference for the certainty of the present to the uncertainty of the future would use a high rate for discounting their investments. Other investors may be more willing to take a chance on forecasts holding true; they would apply a low discount rate, one that makes future cash flows nearly as valuable as today’s.

At times when interest rates are unusually low, however, investors are likely to find very high multiples being applied to share prices. Investors who pay these high multiples are dependent on interest rates remaining low, but no one can be certain that they will. This means that when interest rates are unusually low, investors should be particularly reluctant to commit capital to long-term holdings unless outstanding opportunities become available, with a preference for either holding cash or investing in short-term holdings that quickly return cash for possible redeployment when available returns are more attractive.

In The Alchemy of Finance George Soros stated, “Fundamental analysis seeks to establish how underlying values are reflected in stock prices, whereas the theory of reflexivity shows how stock prices can influence underlying values.”7 In other words, Soros’s theory of reflexivity makes the point that its stock price can at times significantly influence the value of a business. Investors must not lose sight of this possibility.

Most businesses can exist indefinitely without concern for the prices of their securities as long as they have adequate capital. When additional capital is needed, however, the level of security prices can mean the difference between prosperity, mere viability, and bankruptcy.

Investors must remember that they need not swing at every pitch to do well over time; indeed, selectivity undoubtedly improves an investor’s results. For every business that cannot be valued, there are many others that can. Investors who confine themselves to what they know, as difficult as that may be, have a considerable advantage over everyone else.

Value investing encompasses a number of specialized investment niches that can be divided into three categories: securities selling at a discount to breakup or liquidation value, rateof-return situations, and asset-conversion opportunities.

If in 1990 you were looking for an ordinary, four-bedroom colonial home on a quarter acre in the Boston suburbs, you should have been prepared to pay at least $300,000. If you learned of one available for $150,000, your first reaction would not have been, “What a great bargain!” but, “What’s wrong with it?” The same healthy skepticism applies to the stock market.

the first 80 percent of the available information is gathered in the first 20 percent of the time spent. The value of in-depth fundamental analysis is subject to diminishing marginal returns.

Although many Wall Street analysts have excellent insight into industries and individual companies, the results of investors who follow their recommendations may be less than stellar. In part this is due to the pressure placed on these analysts to recommend frequently rather than wisely, but it also exemplifies the difficulty of translating information into profits.

Vickers Stock Research.

Since no investor is infallible and no investment is perfect, there is considerable merit in being able to change one’s mind.

A mitigating factor in the tradeoff between return and liquidity is duration. While you must always be well paid to sacrifice liquidity, the required compensation depends on how long you will be illiquid. Ten or twenty years of illiquidity is far riskier than one or two months; in effect, the short duration of an investment itself serves as a source of liquidity.

When your portfolio is completely in cash, there is no risk of loss. There is also, however, no possibility of earning a high return. The tension between earning a high return, on the one hand, and avoiding risk, on the other, can run high. The appropriate balance between illiquidity and liquidity, between seeking return and limiting risk, is never easy to determine.

This portfolio liquidity cycle serves two important purposes. First, as discussed in chapter 8, portfolio cash flow—the cash flowing into a portfolio—can reduce an investor’s opportunity costs. Second, the periodic liquidation of parts of a portfolio has a cathartic effect. For the many investors who prefer to remain fully invested at all times, it is easy to become complacent, sinking or swimming with current holdings. “Dead wood” can accumulate and be neglected while losses build. By contrast, when the securities in a portfolio frequently turn into cash, the investor is constantly challenged to put that cash to work, seeking out the best values available.

My view is that an investor is better off knowing a lot about a few investments than knowing only a little about each of a great many holdings. One’s very best ideas are likely to generate higher returns for a given level of risk than one’s hundredth or thousandth best idea.

There is nothing inherent in a security or business that alone makes it an attractive investment. Investment opportunity is a function of price, which is established in the marketplace. Whereas some investors are company-or concept-driven, anxious to invest in a particular industry, technology, or fad without special concern for price, a value investor is purposefully driven by price. A value investor does not get up in the morning knowing his or her buy and sell orders for the day; these will be determined in the context of the prevailing prices and an ongoing assessment of underlying values.

The best investment opportunities arise when other investors act unwisely thereby creating rewards for those who act intelligently. When others are willing to overpay for a security, they allow value investors to sell at premium prices or sell short at overvalued levels. When others panic and sell at prices far below underlying business value, they create buying opportunities for value investors. When their actions are dictated by arbitrary rules or constraints, they will overlook outstanding opportunities or perhaps inadvertently create some for others. Trading is the process of taking advantage of such mispricings.

Financial markets are prolific creators of investment opportunities. Investors who are out of touch with the markets will find it difficult to be in touch with buying and selling opportunities regularly created by the markets. Today with so many market participants having little or no fundamental knowledge of the businesses their investments represent, opportunities to buy and sell seem to present themselves at a rapid pace. Given the geopolitical and macro-economic uncertainties we face in the early 1990s and are likely to continue to face in the future, why would abstaining from trading be better than periodically reviewing one’s holdings?

The single most crucial factor in trading is developing the appropriate reaction to price fluctuations. Investors must learn to resist fear, the tendency to panic when prices are falling, and greed, the tendency to become overly enthusiastic when prices are rising. One half of trading involves learning how to buy. In my view, investors should usually refrain from purchasing a “full position” (the maximum dollar commitment they intend to make) in a given security all at once. Those who fail to heed this advice may be compelled to watch a subsequent price decline helplessly, with no buying power in reserve. Buying a partial position leaves reserves that permit investors to “average down,” lowering their average cost per share, if prices decline.

While individual personalities and goals can influence one’s trading and portfolio management techniques to some degree, sound buying and selling strategies, appropriate diversification, and prudent hedging are of importance to all investors. Of course, good portfolio management and trading are of no use when pursuing an inappropriate investment philosophy; they are of maximum value when employed in conjunction with a value-investment approach.

If this book were a fairy tale, perhaps it would have a happier ending. The unfortunate fact is that the individual investor has few, if any, attractive investment alternatives. Investing, it should be clear by now, is a full-time job. Given the vast amount of information available for review and analysis and the complexity of the investment task, a part-time or sporadic effort by an individual investor has little chance of achieving long-term success. It is not necessary, or even desirable, to be a professional investor, but a significant, ongoing commitment of time is a prerequisite. Individuals who cannot devote substantial time to their own investment activities have three alternatives: mutual funds, discretionary stockbrokers, or money managers.

Disclaimer: The information provided on this website is for general informational purposes only and should not be considered investment advice. Please read our full disclaimer for more information. You can access it by clicking HERE.

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