I recently finished Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor by Seth Klarman.
Seth Klarman is a legend. Since the early ’80s, he has delivered a 16% CAGR for his investors. This is amazing considering the size of his fund (Baupost manages $30 billion) and the fact that he frequently holds a lot of cash during bull markets.
He stayed true to his value investing roots. Among the big billionaire “guru” investors still alive today, Klarman is the true disciple of Benjamin Graham-style value investing. While most value investors eventually “graduate” from cigar butt value investing to Buffett-style long-term investing in companies with moats and high returns on invested capital — Klarman stuck to cigar butts. This is particularly interesting considering that he manages $30 billion at his firm, Baupost Group. Usually, the shift from cigar butt investing occurs because it’s no longer scaleable as investors manage too much money. Klarman has been able to keep the party going.
Klarman finds companies that are at a cyclical nadir and sells them once their fortunes have improved. He also does extremely sophisticated investing in things like distressed debt.
He is a quiet guy that doesn’t grant a lot of his interviews. He focuses on his craft and delivers his returns to investors, largely shunning the limelight. Due to the lack of interviews and his legendary investing returns, value investors have been hungry for information about him and his process. They find it in his 1991 book, “Margin of Safety”. The book only sold 5,000 copies when it was originally published and was never re-issued. Due to the small number of copies and the legend of Klarman, copies of the book now sell for $800-$1,000 on Amazon.
I’ve read the classics of value investing and this was one of the few I didn’t read in its entirety. I was glad I did. I think a better title for this book would be “The Intelligent Investor 2.0″. It’s very much a more modern reiteration of the same principles outlined by Ben Graham in “The Intelligent Investor”.
Other possible titles: The Intelligent Investor 2: Electric Boogaloo. The Intelligent Investor 2: Invest Harder. The Intelligent Investor 2: Attack of the Speculators.
Acquiring & Reading the Book (If you want to learn about Margin of Safety, you can skip this ridiculous story)
Getting my hands on a copy of the book was not easy. I found it in Prague and tried to acquire it with a trusted team of colleagues. Unfortunately, we failed. When the situation went bad, my colleagues were murdered in an awful sequence of events. After failing the first time, I tracked down the book to a train moving along the Chunnel in France. The person who had the book tried to escape from the top of the train to a helicopter via a tether. I tied the tether to the train, forcing the helicopter into the Chunnel itself. I acquired the book and then destroyed the helicopter via a chewing gum explosive.
Fearing that the book’s wisdom could be dangerous, I went to a remote cabin to read it. Once I reached the cabin, I read the book out loud. The text was so powerful that it summoned demons, who assaulted me. The ensuing battle with the army of the undead caused me to lose my arm, which I promptly replaced with a chainsaw. Ultimately, the battle opened up a vortex to the year 1300, but that’s another story.
This is actually the plot of the first “Mission Impossible” movie combined with the “Evil Dead” film series.
I read the book on the beach and it was quite pleasant. Anyway, on to the book review!
Speculation vs. Investing
One of the first points that Klarman stresses is the difference between speculating and investing.
As Klarman sees it, understanding this distinction is the key to long-term success. You should ask yourself before making a decision: is this an investment or is this a speculation? I’ll bet that if you asked Klarman, he would say that if you get anything out of the book, understanding this difference is the most important.
What is the difference between speculating and investing? Seth sums it up with this:
“Investments throw off cash flow for owners. Speculations do not. The returns to speculations depend exclusively on the vagaries of the resale market.”
In other words, investments are something for which you can actually calculate a margin of safety or a yield. Your calculations might be wrong, the investment might not be successful, but at least you have a clue about what to expect. Bonds, stocks, private businesses, real estate (with cash flows in the form of rent) — all of these have a defined rate of return. You can figure out what they are worth and purchase them with a margin of safety.
Speculations, in contrast, are things for which your return is dependent solely on what someone else will pay in the future. Obvious examples are collectibles or art. There is no way to determine based on math and financial statements what they are worth. Whether it is a beanie baby or a Picasso, there is no way to determine a margin of safety.
Other, less obvious examples, are respected investment categories like commodities. Buffett frequently makes this point about gold. Gold sits there and doesn’t throw off any cash flow that you can use. There isn’t a way that you can calculate a margin of safety. It’s the same for oil. The asset itself doesn’t produce anything. There isn’t any way you can purchase gold or oil and have a margin of safety.
Real estate doesn’t have a margin of safety unless you plan on renting it out in which case the asset generates cash flow. If you’re buying a house because real estate is “hot” and you think the price will go up, then you’re a speculator.
Cryptocurrency would be another example of speculation. Bitcoin, Ripple, Ethereum. Say what you will about the future of blockchain, but your return on these assets are solely dependent on what other people will pay and there is no way to generate a margin of safety.
Speculations can work out. You can make a lot of money speculating, but keep in mind that it is speculation. The outcome was never certain. There is a high likelihood that the “winners” in speculative assets were simply lucky. Their tales of easy wealth are nothing but survivorship bias.
Graham makes the same points in The Intelligent Investor, but his definition is vaguer. Klarman gets very specific on what is and isn’t investing. The cash flow definition is a great way to think about it.
Of course, the differences between what is speculation and what is investing could be hotly debated. For me, I think Klarman’s definition makes a lot of sense. Examining financial decisions through the “investing vs. speculation” template would likely help many investors avoid a lot of trouble.
If you take a look at an opportunity and it is more of a speculation than an investment, it’s probably a good idea to move on. Only invest in assets for which you can calculate a margin of safety.
Wall Street is not your friend
“If you depend on Wall Street to help you, investment success will remain elusive.”
Klarman points out clearly that Wall Street is not the friend of investors and you should treat their advice and their products with caution. They exist to generate revenue for themselves: typically via underwritings. They are incentivized to earn fees and commisions which often come in the form of investment fads. They do not exist to generate returns or control risk for individual investors.
Seth suggests avoiding IPO’s entirely. When you think through it, investing in IPO’s is nearly always a dumb idea because: 1) The company is going public at a good time for them and they are incentivized to get the best price possible. They aren’t attempting to create a margin of safety for you. 2) The business is often unproven and the investment in the IPO is a speculation on the future, which is unknowable.
Sure, every now and then, you’ll hit a home run like Google, Facebook, or Microsoft. Those home runs are impossible to predict. Klarman explains:
“Investors even remotely tempted to buy new isssues must ask themsleves how they could possibly fare well when a savvy issuer and a greedy underwriter are on the opposite side of every undewriting. Indeed, how attractive could any security underwriting ever be when the issuer and underwriter have superior information as well as control over the timing, pricing, and stock or bond allocation? The deck is almost always stacked against the buyers.”
The history of Wall Street is a history of fads that end badly for investors and every bull market has a new take on the oldest stories in Finance. Klarman spends a lot of time discussing the investment fads of the 1980s: namely, the junk bond craze and the corresponding bad behavior that went along with it. If you want to read more about the behavior of this time period, I would recommend reading Liar’s Poker by Michael Lewis. The Predator’s Ball and Den of Thieves are also good summaries of the period.
While Klarman focuses on the insanity of the 1980s, it’s important to keep in mind that every bull market exhibits this kind of behavior. What’s important for investors is to identify this behavior and avoid it.
Klarman also warns against Wall Street research. Wall Street research departments have a bullish bias. This exists for a few reasons, but chiefly it is because they have a vested interest in stocks increasing and they want to maintain close relations with companies so they can generate income from new issues of debt and equity.
He points to an example of Marv Rothman, who was fired from his job as an analyst at Janney Montgomery Scott in 1990. Marv wrote a critical analysis of Donald Trump’s casino empire, arguing that Trump was overleveraged and wouldn’t be able to meet his debts. Marv turned out to be correct, but he was fired because his firm wanted to make deals with Trump to generate income.
This continues to this day. Consider the bullish ratings on Enron that went on to nearly the very end or the lack of “sell” ratings in all market environments.
As Gordon Gekko put it, if you want a friend, get a dog. Wall Street and much of the financial world is not your friend. There are certainly good people on Wall Street and the financial world, but your instinct should be cautious. As Ronald Reagan put it, “trust but verify”.
“Like dogs chasing their own tails, most institutional investors have become locked in a short-term, relative-performance derby.”
Klarman also points out that Wall Street is entirely focused on short-term performance. They obsess over how much they lag the market benchmarks. This causes them to operate as a herd, buying and touting the same investments like lemmings to avoid falling behind the averages.
You see the herd behavior not only in individual stocks but in entire investment classes. In the late ’80s it was Japan. In the mid-2000s obsession with emerging markets, the late ’90s obsession with dot-coms, or the current obsession with cryptocurrency and disrupters. They use the same buzzwords, they invest in the same things. A good investor ignores this noise.
He also points out that the more money an institutional investor manages, the less likely it is that they can deliver impressive results. They also engage in “performance dressing,” whereby at the end of every quarter and year they try to stuff their portfolios with the best-looking stocks and discard the weakest performers. This is the opposite of what a savvy investor would actually do.
Fortunately, Klarman believes that these activities and these flaws can be exploited by smaller investors. By looking at what Wall Street is getting rid of recklessly (like panic selling in a stock getting thrown out of an index, spin-offs sold without rhyme or reason, etc.) there is often value in these situations.
“Picking through the crumbs left by the investment elephants can be rewarding.”
Margin of Safety = Avoidance of Losses
“Most investment approaches do not focus on loss avoidance or an assessment of the real risks of an investment compared with its return. Only one that I know does: value investing.”
In Klarman’s view, the most critical aspect of value investing as an investment philosophy is the avoidance of losses. In Klarman’s view, the purpose of buying stocks with a margin of safety is the minimization of risk. The margin of safety is thought of as a margin for being wrong.
“The problem with intangible assets, I believe, is that they hold little or no margin of safety.”
Klarman is a classic cigar butt value investor. He is skeptical of the Buffett approach which emphasizes enduring value created by strong franchises and moats. Klarman believes in classic Graham-style investing. He believes you should wait until you have a clearly defined margin of safety and only buy when a sufficient margin exists.
“Sometimes dozens of good pitches are thrown consecutively to a value investor. In panicky markets, for example, the number of undervalued securities increases and the degree of undervaluation also grows. In buoyant markets, by contrast, both the number of undervalued securities and their degree of undervaluation declines.”
Klarman agrees with Buffett’s view that the key to investing is “waiting for the right pitch”. In other words, securities markets constantly offer new securities at different prices. You don’t have to figure out every situation as you don’t have to swing at every pitch. You don’t have to swing at every one. You don’t have to remain fully invested.
Klarman vs. Academics
“Value investing is, in effect, predicated on the proposition that the efficient market hypothesis is wrong.”
“Even among the most highly capitalized issues, however, investors are frequently blinded by groupthink, therebycreating pricing inefficiencies.”
Klarman thinks that the efficient market hypothesis is bunk. The academics argue that markets are mostly efficient and incorporate all available information at any given time. There are therefore no “mispriced securities”. Klarman dismisses this.
“Technical analysis is indeed a waste of time.”
Additionally, Klarman also dismisses the entire field of chart reading and technical analysis. A chart is a reading of Mr. Market’s sentiment about a stock. He believes that you should try to profit from Mr. Market’s folly and not pretend that there is an wisdom that can be gleamed from a chart. Time is better spent researching the business and attempting to determine your margin of safety.
“I find it preposteorous that a single number reflecting past price fluctuations could be thought to be completely describe the risk in a security. Beta views risk soely from the perspective of market prices, failing to take into consideration specific business fundamentals or economic developments.”
“If you are buying sound value at a discount, do short-term price fluctuations matter? In the long run they do not matter much; value will ultimately be reflected in the price of the security.”
Klarman is also strongly critical of the academic’s notion of “beta”. Academics view beta as the underlying volatility of a stock and that is their preferred measure of risk. Klarman believes this is bunk and thinks you should focus on risk in the sense of (1) whether or not the business itself can cause a permanent loss of capital or (2) if you are making the purchase with a margin of safety.
What was the beta of mortgage-backed securities before their collapse? They likely showed very little volatility, but this was meaningless as the underlying underwriting standards were collapsing.
I majored in Finance in college and the focus of the curriculum was almost entirely on the different aspects and permutations of the efficient market hypothesis. I didn’t believe it then and I don’t believe it now. Looking at the history of markets, I see absolutely no evidence that they are efficient. We witnessed a bubble in internet stocks, a bubble in real estate and now we’re witnessing a bubble in cryptocurrencies. The markets are insanely volatile and will continue to do so. 50% drawdowns occur once every 20 years. 20-30% reductions occur once every 5 years. The underlying businesses that make up the indexes haven’t experienced this level of volatility. Mr. Market is a far more instructive way to describe markets than the capital asset pricing model.
As Joel Greenblatt likes to point out, look at the 52 week highs and lows of popular stocks. Did the actual business prospects of those firms experience the wild price swings of their stocks? Of course not.
Value Investment Philosophy
“Value investing is a large-scale arbitrage between security prices and underlying business 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 asses underlying value. The hard part is discipline, patience, and judgment.”
Klarman identifies three key components of a value investment strategy:
- Bottom-up investing. Klarman recommends ignoring macroeconomics and focusing on specific businesses. He refers to this as “bottom-up” investing. Starting with the company itself, then worrying about the macroeconomy. This is in contrast to “top-down” investors who focus on the macro picture. As Klarman sees it, this is simply too hard for anyone to successfully implement over time. I believe he’s right. Think of all of the so-called “gurus” of macro who predicted the 2008 crisis. Have any of them been able to successfully forecast the last decade of a bull market? Most of them predicted unrealized bouts of hyperinflation and saw bubbles in everything from commercial real estate to municipal bonds.
- Absolute performance orientation. Klarman thinks you should ignore the rest of the market completely and focus on your own returns. Concentrating on what the rest of the market is doing can cause you to make stupid decisions to keep up with other investors. The reason that professionals frequently underperform the averages is, ironically, because of their relative performance orientation. Focusing on relative returns prevents them from doing anything differently than the averages.
- Paying careful attention to risk. Risk is defined not as the academic notion of beta, but the probability and amount of loss due to permanent value impairments.
“Business valuation is a complex process yielding imprecise and uncertain results. Many businesses are so diverse of difficult to understand that they simply cannot be valued. Some investors willingly voyage into the unknown and buy into such businesses, impatient with the discipine required by value investing.”
After discussing the merits of valuing a business separate from the market price, Klarman goes on to provide his opinion about different methods of business valuation. He examines the different forms of business valuation and looks at it as a complex art. Different valuation techniques should be used for different kinds of business. There isn’t any kind of “one size fits all” approach to valuation. Most importantly, Klarman recognizes that some businesses cannot be valued. A fast-growing company with a brand new product, for instance, is impossible to value correctly because there are simply too many unknowns. Valuation is hard enough to figure out with a stable company, let alone brand new companies with a million different rapidly changing variables.
- Liquidation value – Liquidation value, net current asset value, or net working capital is the purest measure of a business’s worth. In Klarman’s view, the best time to use this analysis is when the business is unprofitable.
- Net present value – He suggests using net present value when looking at a very stable business with predictable cash flows. In other words, a net present value or assessment of discounted cash flows should not be used in all circumstances. It should only be used if the business is predictable and the assumptions are extremely conservative. It is easy to game this kind of analysis, so it is important to use this with caution and conservatism.
- Earnings – Klarman cautions against earnings provided by the business as they are frequently subject to manipulation by unscrupulous management. It’s important to dig into the earnings and assess whether or not they are real.
- Book value – Klarman cautions against the use of book value as the value on the balance sheet isn’t necessarily accurate. Inflation can rapidly increase the price of real estate holdings, for instance. Technological change can rapidly depreciate the usefulness of plant, property, and equipment. These changes aren’t always captured on the balance sheet. Klarman doesn’t look at book value alone as a particularly useful tool for assessing the worth of a business. Balance sheet analysis should be deeper.
- Dividend yield – Klarman cautions against looking solely at dividends in assessing value. He points out that some businesses are simply terrified to cut a dividend even if the business is falling apart, which in effects turns the dividend into a liquidation that ultimately destroys value.
Finding Value Opportunities
“Computer-screening techniques, for example, can be helpful in identifying stocks of the first category: stocks selling at a discount from liquidation value. Because databases can be out of date or inaccurate, however, it is essential that investors verify that the computer output is correct.”
In the hunt for areas that value investors can exploit, Klarman recommends a number of key areas. The first, and most obvious, is looking for cheap stocks with the use of screening. Klarman restricts this to liquidation or net-net scenarios, but I believe that the use of screening among other methods of statistical cheapness is just as valid.
However, Klarman cautions that you should investigate the numbers in the screener for yourself. Find the financial statements (which you can easily do at sec.gov) and confirm that the numbers match the valuation output from the screener.
Klarman believes that you should research an understand your positions, but also cautions against doing too much work. There is only so much that can be known and the research process is subject to diminishing rates of return. This is also a reason that we should buy stocks with a margin of safety. Because all of the facts aren’t knowable, it’s important to have a margin of error built into the analysis.
“Out-of-favor securities may be undervalued; popular securities almost never are. What the herd is buying is, by definition, in favor.”
He talks about many of the same things as Greenblatt: spin-offs, share buybacks, recapitalizations, asset sales, bankruptcies, liquidations. He also discusses thrift conversions (an area exploited by Ed Thorp as explained in A Man for all Markets).
Klarman also devotes a chapter to discussing the value in distressed debt. I actually work in operations for a bank and deal extensively with distressed debt. He’s right: the opportunities are enormous. Unfortunately, they are difficult to exploit for small-time investors. Usually, you need to be an accredited investor to buy these assets. They are also subject to minimum transfer requirements, which are normally at least $1 million. For hedge funds and big investors like Klarman, they are an attractive area to exploit. For small investors like myself, not so much.
Klarman can also hire forensic accountants and lawyers to dig into distressed situations and find out if there is any underlying value. This is simply beyond my capabilities or those of most small investors.
With that said, it is still fascinating to read his process and how he categorizes the different types of distressed opportunities.
I highly recommend that you read a copy of Margin of Safety. There is a reason that the book is so feverishly sought after. Klarman clearly communicates the key principles of value investing for small investors.
To summarize some of his key points:
- Clearly understand the difference between investing and speculation. Avoid speculations at all costs. An investment is something which currently (or will in the future) generate cash flow and a speculation is an asset that generates no cash flow for which you are attempting to re-sell at a higher price in the future.
- Margin of safety is designed to minimize losses and controls for your investment thesis being wrong. The future is unknowable and a margin of safety is a way of protecting yourself from what could go wrong.
- Business valuation is complex and can involve many different kinds of analysis. There is no one-size-fits-all approach. It’s important to use the appropriate technique (or overlapping techniques) depending on the situation you are presented with. Avoid situations where value cannot be calculated.
- When dealing with financial professionals and Wall Street, always remember that they are not on your side. Avoid Wall Street fads. Do your own homework. Remember that investment professionals and Wall Street firms have their own incentives which may not align with yours.
- The efficient market theory and the concept of beta are nonsense.
- Avoid top-down macroeconomic analysis. Macro is too hard and there is too much room for error. Bottom-up investing on a case by case basis will lead to better results. I’m definitely guilty of this, but do my best to try to avoid it.
- Adopt an absolute performance orientation. Constantly comparing your returns relative to a benchmark over short-term time periods can lead to bad decisions in an effort to keep up. The irony here is that focusing on absolute returns ends up crushing the averages over long stretches of time, as Klarman proved throughout his career. I admit this is hard for me after lagging the S&P 500 last year, but I know it’s something I need to constantly keep in check. The biggest challenge in investing is managing your emotions.
- Klarman thinks technical analysis is a waste of time and I agree with him. A stock chart is a reading of Mr. Market’s sentiment. Value investors are trying to profit from Mr. Market’s folly. Reading the chart is getting get sucked into Mr. Market’s insane game. You are trying to exploit Mr. Market, not get caught up in his capacity for manic euphoria and bouts of depression. In the time you spend trying to find head-and-shoulders patterns, finding Fibonacci sequences, consulting tarot cards, looking at astrology, applying calculus to chart movements, calculating Elliot Waves, comparing a chart to 1987 or the Nikkei, etc. – you could be researching the business and trying to asses value.
Unrelated. This is great:
PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings. Read the full disclaimer.