Discovering the 25 biggest learnings of Seth Klarman’s classic “Margin of Safety”.
Seth Klarman‘s book “Margin of Safety, Risk Averse Investing Strategies for the Thoughtful Investor” is a highly sought-after classic which describes the fundamentals of his value investing philosophy.
The book was released in 1995 and has amassed a cult following as it has been out of print for quite some time. Unfortunately only 5000 copies have been printed and therefore the book is hard to come by. According to Bloomberg it is one of the most waitlisted books in university libraries and is frequently claimed as lost there.
This post takes a look at the biggest learnings from the book.
Value investing is the discipline of buying securities at a discount below their fundamental value and selling them once their price reflects fundamental value. They tend to be risk-averse investors who only invest when they can fully understand a security and when a sufficient discount exists.
“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.”
Finding investments which are being sold below their fundamental value is hard. It requires a lot of patience as value is often well hidden. Even the cheapest security in an overvalued market can still be overvalued. However buying only when a sufficient discount is given is the prerequisite to successful value investing.
“Holding a contrarian opinion is not always useful to investors, however. When widely held opinions have no influence on the issue at hand, nothing is gained by swimming agains the tide.”
Value investors are contrarians who stand apart from the crowd and challenge conventional ideas. As they are acting against the crowd they may incur poor performance for extended periods of time. Therefore buying undervalued securities itself is not a guarantee for success.
Rather investors have to know why the security is undervalued and what catalyst will trigger it to be correctly valued in the future. Catalysts for moving the price of a security towards their underlying value can be share buybacks, spin-offs, recapitalizations, liquidations of business branches or external forces such as takeovers or proxy fights.
Many investors adopt investing approaches with little long-term success which are often driven by greed and the latest fad of Wall Street. Other investors follow strategies which are completely detached from business fundamentals, such as investing into index funds, in order to gain mediocre results.
“The greatest challenge is maintaining the requisite patience and discipline to buy only when prices are attractive and to sell when they are not, avoiding the short-term performance frenzy that engulfs most market participants.”
Value investing on the other hand has a proven record of delivering long-term gains with limited downside risk. However it requires a lot of work, discipline and a long-term investment horizon which leads many investors to go for the quick buck instead. For other the temporary price fluctuations of a security rather than its inherit value are the basis of their investment.
“The most beneficial time to be a value investor is when the market is falling. This is when downside risk matters and when investors who worried only about what could go right suffer the consequences of undue optimism.”
Investors often suffer from their own emotional reactions to market developments. Rising prices lead to over-optimistic high-risk investments while falling prices lead to losses as a result of ignoring business fundamentals. For value investors those emotional reactions create many attractive opportunities to buy securities below value with limited risk.
The efficient market hypothesis declares that all market participants have the same information available to them and therefore act rational and efficiently. However in practice this often is not true as many market participants are guided by emotions like greed or fear rather than by fundamental value. Value investing essentially bets on the efficient market hypothesis being wrong.
“Value investing is, in effect, predicated on the proposition that the efficient-market hypothesis is frequently wrong.”
While the pricing of large-cap stocks tends to be generally more efficient, small-cap stocks, distressed bonds and other less-popular investments tend to be less efficiently priced due to irrational behavior of investors. However even amongst large-cap stocks investors can be misguided by market trends and a mistaken consensus. Therefore investors are more likely to find bargains with a sufficient margin of safety in these areas of the market.
Prices tend to change for two reasons: Either the underlying value of the security has changed or the price reflects short-term changes in supply and demand.
“Value in relation to price, not price alone, must determine your investment decisions”
In the short-run securities are subject to supply and demand. Reasons for that can be year-end tax selling, negative press or institutional investors pulling out of the security. Index funds might hijack prices as they invest regardless of the price of a security. A higher trading volume might also attract traders and speculators who bid of the price for short-term gains. If investors face a margin call they have no choice but to sell regardless of fundamental value. Finally, when companies report better or worse financial results than expected it also directly affects the price of the security in the short-term.
There are also outside effects for changing prices such as a decline in interest rates or a change in corporate tax rates.
Most of these influences are temporary and don’t affect the price in the long-term. In the long-term prices always tend to adapt to the underlying value of the security.
“The best investment opportunities arise when other investors act unwisely thereby creating rewards for those who act intelligently.”
Investors should avoid to keep holding investments purely in the expectation that the price keeps rising. The same applies to selling when the price falls without considering underlying value. If the price of a security is falling but the fundamental value is unchanged it represents an ideal buying opportunity.
There is no clear definition of risk in investing. Some investor define risk as being correlated with return. According to them the higher the risk the higher the possible return. Others equate risk to volatility in the price of a security.
“Rather, risk is a perception in each investor‘s mind that results from analysis of the probability and amount of potential loss from an investment.”
According to Klarman risk however is buying overpriced securities at the wrong price. The risk therefore is dependent on the possible outcomes relative to the price paid. For most investments the risk can only be known after the maturity or sale of the security. However unlike the final profit the risk cannot be defined by a single number.
“While investors should obviously try to avoid overpaying for investments or buying into businesses that subsequently decline in value due to deteriorating results, it is not possible to avoid random short-term market volatility.”
Often specific types of securities are believed to have specific risk intrinsic to them. This riskiness is defined by beta which indicates if a stock is likely to rise or fall more than the average stock. However it fails to incorporate the fundamentals of the business and judges risk solely based on the price paid. Therefore it ignores the influence investors themselves have on reducing risk for example by using their voting rights in their favor.
“Security holder who need to sell in a hurry are at the mercy of market prices. The trick of successful investors is to sell when they want to, not when they have to.”
The future is unpredictable and unexpected events such as pandemics causing market declines can happen at any time. Hence it is important for investors to be prepared for any circumctances and forego a near-term return as a insurance premium against unexpected events.
It is impossible to predict whether the value of a security will rise or fall. As a result valuation should be performed conservatively and investor should include a safety buffer, a margin of safety, in their estimated value in order to protect themselves from losses.
“Value investors, by contrast, have as a primary goal the preservation of their capital. It follows that value investors seek a margin of safety, allowing room for imprecision, bad luck or analytical error in order to avoid sizable losses over time.”
The margin of safety is achieved when buying the security significantly below the underlying value of the security. The size of the margin of safety is dependent on the risk and error tolerance of the investor as well as volatility that the security is expected to be able to sustain. There is no standard for the margin of safety and the size ultimately depends on the investor.
Value investing is a bottom-up strategy which entails the identification of undervalued investment opportunities which are then measure using their absolute-performance. Bottom-up investors focus on analysing the objective fundamental value of a business and therefore only have to make limited predictions about the future. They choose to only invest if attractive opportunities exist and hold cash if none are available.
“The top-down investor thus faces the daunting task of predicting the unpredictable more accurately and faster than thousands of other bright people, all of them trying to do the same thing.”
Top-down investors on the other hand approach investing by making a predicition about the future and then picking investments based on that prediction. This approach is highly vulnerable to human error as the top-down investor must be correct on all aspects of the prediction. As top-down investors buy based on a theme or event there is no margin of safety.
Bottom-up investors can easily determine when their investments should be sold as the whole reason for making the investment in the first place was their fundamental analysis. Once the underlying value is reached there is no reason to keep holding the position. Top-down investors on the other hand have no clear guidance when their assumptions became invalid.
Investors who measure performance relative to a subjective metrics such as a market index or relative to other investors tend to be fully invested. Being fully invested makes sense for them as having idle cash would result in a underperformance of the relative metric that they attempt to match.
“In investing, there are times when the best thing to do is nothing at all.”
Absolute-performance oriented investors on the other hand prefer to only invest when investments meet absolute standards of value. Available opportunities both need to be readily available and be attractive enough to warrant the risk. Therefore absolute-performance oriented investors tend to take a long-term perspective.
“The liquidity of cash affords flexibility, for it can quickly be channeled into other investment outlets with minimal transaction costs.”
As absolute-performance oriented investors tend to hold cash if no opportunities exist they are able to take advantage of falling markets. Fully invested investors on the other hand will see prices decline and will be forced to sell if they want to maintain the performance relative to their tracked index.
Investors can benefit greatly from understanding how Wall Street operates and what influences it has on regular investors. Wall Street makes money by earning commissions on transactions between buyers and sellers, by arranging the sale of securities, underwriting new securities, providing advice or by investing their own capital. As a result they get mainly paid for what they’re doing rather than how effectively they do it.
“The great majority of institutional investors are plagued with a short-term, relative-performance orientation and lack of long-term perspective that retirement and endowement funds deserve. Myriad rules and restrictions, often self-imposed, also impair the ability of insititutional investors to achieve good investment results.”
For example Wall Street might be motivated to sell high-commission securities to customers rather than securities which work well for their customers financial objectives. This creates a bias for frequent rather than profitable transactions. This bias results in a focus on short-term performance which rarely goes beyond the current transaction. It is intensified by the high wages earned on Wall Street which motivate bankers to focus on their own wealth rather than the wealth of their clients.
“The buy side and sell side in effect become co-conspirators, each having a vested interest in the continued success of the innovation.”
New financial products also tend to mainly benefit the investment bankers and institutional investors. They can earn fees and commission with minimal risk from these new financial innovations. In the end the buyers and sellers become independent on each other as they depend on the continued success of the financial product. However early success is usually not a reliable indicator for continued success as long-term consequences have not been considered thoroughly.
Wall Street also tends to have a bullish bias as more fees and commissions can be earned in a rising market. This bullish bias is also shared by publicly traded companies as well as regulators. For companies a positive outlook is the main condition for raising additional funding or increasing management compensation. Similarly regulators want to maintain investor confidence which is easier in a bullish market. This is illustrated by circuit breakers which protect the market from downward price trends but don’t intervene in speculative upward price movements.
“Investors even remotely tempted to buy new issues must ask themselves how they could possibly fare well when a savvy issuer and greedy underwriter are on the opposite side of every underwriting.”
Another good example where the motivation of the issuer of a security does not align with investors are initial public offerings. IPOs often serve as a way for existing shareholders to sell their shares at a profit rather than to offer capital to underfunded businesses with potential. The issuers and underwriters of a security have better information as well as control over the price and timing of the IPO and therefore investors are at a signifant disadvantage.
As most institutional money managers are compensated by total assets under management their main incentive is to generate more fees and increase managed capital rather than to increase wealth for their clients.
In large financial institutions there is usually a separation between portfolio managers and analysts with portfolio managers being the decision makers. This creates potential for mistakes as the portfolio managers are not the ones who made the analysis of the security.
“Since the average institutional investor has underperformed the market for the past decade, and since all investors as a group must match the market because they collectively own the entire market, matching it may seem attractive.”
Often clients replace the worst-performing money managers which creates a situation in which money managers avoid to stand apart from the crowd in order to maintain their status which results in average results for clients. As a consequence it is hard for money managers to establish a long-term view which leads them to chase short-term performance. It also results in irrational behavior such as selling worst-performing assets to increase quarterly return metrics.
“Any institutional investor with an innovative or contrarian investment idea goes out on a limb. He or she assumes a personal risk within the firm, which compounds the investment risk.”
Money managers tend to avoid selling securities. Firstly in order to avoid underperformance they usually hold onto fully priced or overpriced securities until a consensus that they are indeed overpriced has emerged. At the same time disposing of institutional-sized positions simply is not as easy as a purchaser with the required funds has to be found. Finally selling creates additional work and costs which make holding onto assets easier for the money manager.
An index fund, like ETFs, follows a market index such as the S&P 500. They offer the advantage of low-transaction costs as there is almost no trading activity and guarantee a return similar to the tracked index. However index funds are a self-fulfilling prophecy. The more investors follow an index the more inefficient the market becomes as less and less investors perform fundamental research into the securities they purchase.
“An index fund manager does not look to buy or sell even at attractive prices. Even more unusual, index fund managers may never have read the financial statements of the companies in which they invest and may not even know what businesses these companies are in.”
Another downside is the potential to move the market simply by following the index. If a security leaves the index it has to be replaced by all portfolio managers of index funds at the same time resulting in artificially bloating its price. In the end the investors of the index fund simply pay more for the security because it became part of the tracked index.
Many investors aim to attach fixed values to their potential investments. However business value is not precisely knowable and is subject to several external factors such as price fluctuations or the state of the general economy. Unlike debt instruments they also don’t have contractual cash flows which would make valuation simpler. Therefore investors have to constantly reevaluate their fundamental analysis of a security based on the latest information known to them.
“First, no matter how much research is performed, some information always remains elusive; investors have to learn to live with less than complete information.”
Furthermore different investors come to different fundamental values based on their analysis. These values can differ based on their expected future outlook, different intended uses of assets or different discount rates of cash flows. As a result every security has a range of possible values.
“Investors are in the business of processing information, but while studying the current financial statements of the thousands of publicly held companies, the monthly, weekly, and even daily research reports of hundreds of Wall Street analysts, and the market behavior of scores of stocks and bonds, they will spend virtually all their time reviewing fairly priced securities that are of no special interest.”
When a bargain has been found it should be inspected thoroughly as many undervalued securities look more interesting than they actually should be. There might be fundamental reasons for the depressed price such as pending litigations or competitors introducing a better product. Identifying those underlying reasons makes the possible outcomes more predictable and therefore reduces investment risk.
“Usually investors have to work harder and dig deeper to find undervalued opportunities, either by ferreting out hidden value or by comprehending a complex situation.”
However there will always be unknown information no matter how much research investors perform. And even if all information would be available the value of in-depth research is subject to diminishing returns. As the market always changes it becomes a never-ending task to acquire up-to-date information on a given security and the required effort simple is not worth the it.
One encouraging sign when analyzing investments is whether the management of a business is buying their own stock. As Management usually knows the situation of the business best this is a great indicator for success. While they don’t control the stock price itself their actions can have a significant impact on it.
There are also pitfalls which can make a company seem more valuable than it actually is. For example corporate write-offs are usually greeted enthusiastically by investors. As the underperforming assets are being removed from the balance sheet this artificially are being projected into the future and many investors predict a higher valuation in return.
Another pitfall is the over-reliance on book value. Book value is the shareholders equity that is left when subtracting all liabilities from all assets. While historical book value seems like a good indicator to judge the growth of a company it can be misleading as the real value of assets depends on factors such as inflation, technological change or regulation.
Similarly dividend yields are often misleading. Companies in bad shape tend to offer high dividend yields to attract investors. This causes the companies to slowly liquidate by paying out its value rather than to generate new value based on its assets.
It is important to consider what catalysts exist for the realization underlying value. Some catalysts are at the discretion of the management such as share buybacks. Others are external and often related to the voting control of a company. The accumulation of voting right or the fear of this happening can lead to efforts to increase the stock price.
Catalysts can both lead to the full realization of value, for example through the liquidation of the company, or to partial realization, for example through spin-offs. The absence of a catalyst will most likely lead to the erosion of the fundamental value.
Historically investors used reported earnings to value public companies while private buyers of entire companies used free cash flow. This changed in the 1980s when investors in public companies started to also use free cash flow. They sought after a single metric to define the cash-generating ability of a company: EBITDA (earnings before interest, taxes, depreciation and amortization).
However EBITDA can mislead investors looking for undervalued companies. First it prefers businesses using extensive debt. The interest expense is tax-deductible and therefore pretax earnings are available to pay for interest expenses therefore increasing free cash flow compared to non-leveraged companies.
“Those who used EBITDA as a cash-flow proxy, for example, either ignored capital expenditures or assumed that businesses would not make any, perhaps believing that plant and equipment do not wear out.”
Secondly depreciation and amortization can skew the result of EBITDA. Deprecitation reduces reported profits but not cash. Rather they contribute to cash but must eventually be used to fund capital expenditures. This means that cash has to be available when these capital expenditures have to be taken. However the depreciation does not guarantee that the cash is indeed available.
The most important goal of every investor should be the avoidance of losses. This can be hard to achieve when the overall market follows the latest trends guided by greed. However loss avoidance is the best way to achieve a profitable outcome.
“I too believe that avoiding loss should be the primary goal of every investor. This does not mean that investors should never incur the risk of any loss at all. Rather ’don’t lose money’ means that over several years an investment portfolio should not be exposed to appreciable loss of principal.”
This sentiment runs contrary to the current market environment in which owning stocks is considered to be safer than cash or bonds. It is driven by the believe that with index funds investors can match the market performance.
However investors should not forget that their equity in a company is junior to that of debt. So in case of a bankruptcy they will only receive money back if all liabilities have been satisfied. This makes debt instruments inherently safer but also less profitable.
Another common pitfall is that investors set themselves specific rate of returns which they aim to achieve. However setting the expected return does not guarantee its achievement. It leads investors to focus mainly on the opportunities rather than the risks and in turn promotes speculative behavior. This can cause severe losses if the price of security is not warranted by its underlying value. Klarman advises to target risk rather than a desired rate of return as an investment goal.
Most investors believe that high returns can only be achieved with high risk. However the contrary is often true. A trendy and overvalued security is much riskier than an undervalued and out-of-favor one. The overvalued security can go down at any time while the undervalued security has risk priced in and is more likely to go up. Undervalued securities can also be real bargains which sometimes sell below their fundamental value.
According to Klarman investors will fare much better by achieving consistently good returns with limited downside risk compared to volatile returns based on speculative investments. The reason for that is that even one larger loss can destroy the effects of compounding value over time.
Many value investing opportunities can be found outside the stock market. For example investors often avoid investments into corporate liquidations. A company might either voluntarily liquidate to prevent the wipeout of remaining shareholder value. Others might liquidate in order to improve taxes, because of persistent undervaluation or to escape corporate raiders. As these liquidations are often avoided by other investors they can present great opportunities for value investors.
Other interesting opportunities might be complex financial securities which have contractual cash flows and therefore guaranteed returns. These usually are nether stocks nor bonds and offer great returns for limited risk due to their unique and obscure conditions.
Similarly rights offerings can be attractive investments if prices rightly. While in an IPO new investors dilute shares of other investors in a rights offering the proportional interest of each shareholder is preserved. They retain their percentage interest but have more money invested.
Risk arbitrage situations also can be interesting investments. Examples for risk arbitrage are spin-offs, liquidations or corporate restructurings. Contrary to other securities the gain or loss from a risk arbitrage situation typically depends on the successful completion rather than underlying value.
A good example of a risk arbitrage situation are spin-offs. Companies usually spin-off parts of their business when they no longer serve the purpose of the company or if the company wants to improve their financial results. Existing shareholders usually receive shares in the spun-off company. As the newly spun-off company is usually less attractive due to the same reasons for which it was spun-off the share price usually is depressed. This makes it an ideal value investing opportunity. However sometimes the opposite is true and the shares of the parent company becomes much more attractive after the spin-off.
While many investors are confident in their decision to purchase a security the decision to sell is often much harder. A diminishing margin of safety due to rising prices increases the risk and presents an ideal opportunity to sell. The decisions to sell should be based on the fundamental value of the security.
If better opportunities exist it might not be worth it to squeeze out minor returns of existing investments. However when an investment is still greatly undervalued it should probably not be sold.
The right time to sell also depends on the availability of buyers as well as the existence of other opportunities.
Apart from picking new investments investors have to manage their portfolio. Investors have to stay stay updated on their holdings to find the right time to sell. Additionally they have to maintain appropriate diversification, manage cash flow and liquidity and make hedging decisions. While the analysis of individual investments provides risk management the management of a portfolio provides further risk management through diversification and hedging.
“Diversification for its own sake is not sensible. This is the index fund mentality: if you can’t beat the market, be the market.”
Investors are well advised to diversify their holdings. Seth Klarman recommends to own between ten to fifteen securities in a portfolio. However diversification for the purpose of diversification is not enough. For example a diversified portfolio of purely overprices securities is risky despite its diversification.
Similarly to diversification, hedging can reduce investment risk. While the risk of the overall falling market cannot be avoided through diversification, hedging can. However it is not always smart to hedge. Sometimes it makes sense to incur risk and remain unhedged if available returns are sufficient as hedges can be expensive and time-consuming.
Very few investors require a completely liquid portfolio which can be turned into cash at any moment. However maintain some liquidity is important and investors should demand sufficient compensation for bearing illiquidity. Generally investors should lean towards illiquidity when the market compensates well while leaning towards liquidity when the market doesn’t. The required compensation depends on how long an investor will have to bear illiquidity.
“Investing is in some ways an endless process of managing liquidity. Typically an investor begins with liquidity, that is with cash that he or she is looking to put to work. This initial liquidity is converted into less liquid investments in order to earn an incremental return. As investments come to fruition, liquidity is restored. Then the process begins anew.”
The market constantly changes and new undervalued securities will arise. Therefore value investors should monitor their portfolio and realize the value of investments which have appreciated to their fundamental value. It can even make sure to sell the least undervalued securities if a security has not realized its full value or if the position might be at a loss. This opens up capital to invest into better opportunities which can arise.
“Investors must recognize that while over the long run investing is generally a positive-sum activity, on a day-to-day basis most transactions have zero-sum consequences.”
Ideally investors refrain from buying a full position. Rather they should buy a partial position at first and keep reserves in order to average down if the price falls further.
As explained in our post about the difference between trading and investing investors believe that the price of a security tends to reflects its underlying value over the long run. To them an investment is a ownership of the value provided by the security. Speculators on the other hand buy and sell securities based on whether they believe the price will rise of fall in the future. Therefore their predictions are not based on the underlying value but on the expected behavior of other market participants.
“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”
The main difference between investments and speculations might not be immediately clear as both can be bought and sold and generate investment returns. The big difference is however that investments return cash flow for the owners while the return of speculations solely depends on the willingness of others to buy the security.
A good example for this are collectible items which return no cash flow to their owners. They are subject to supply and demand of the collectible market. On the other hand even long-term investments such as planted timber sooner or later generates cash.
“You may find a buyer at a higher price – a greater fool – or you may not, in which case you yourself are the greater fool.”
As trading is pure speculation there is a high risk that there is no new buyer available to purchase an overvalued security. As a result Klarman advises that fundamental investors should avoid situation in which they hold overpriced investments which have to be sold at some point.
Continue with the next lesson of our beginner-friendly guide “Popular Investors”.