Lessons from Seth Klarman's "Margin of Safety"

Why Margin of Safety

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 the bargain is the key to the process. 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. Value investors seek a margin of safety, allowing room for imprecision, bad luck, or analytical error in order to avoid sizable losses over time.

A margin of safety is necessary because…

  • Valuation is an imprecise art

  • Future is unpredictable, and

  • Investors are human and do make mistakes

Value Investing isn’t Easy

Being a value investor usually means standing apart from the crowd, challenging conventional wisdom, and opposing the prevailing investment winds

Three Elements of Value Investing

  • Bottom-Up:

Value investing employs a bottom-up strategy by which individual investment opportunities are identified one at a time through fundamental analysis. Value investors search for bargains security by security, analyzing each situation on its own merits. Then they must exhibit the patience and discipline to wait until a bargain emerges from their searches and buy it, regardless of the prevailing direction of the market or their own views about the economy at large.

  • Absolute-Performance Orientation:

Value investors are absolute-performance oriented; they are interested in returns only insofar as they relate to the achievement of their own investment goals, not how they compare with the way the overall market or other investors are faring. Absolute- performance oriented investors are likely to prefer out-of-favor holdings that may take longer to come to fruition but also carry less risk of loss.

  • Risk and Return:

While most other investors are preoccupied with how much money they can make and not at all with how much they may lose, value investors focus on risk as well as return

Value Investing and Contrarian Thinking

  • Value investing by its very nature is contrarian.

  • Out-of-favor securities may be undervalued; popular securities almost never are.

  • What the herd is buying is, by definition, in favor. Securities in favor have already been bid up in price on the basis of optimistic expectations and are unlikely to represent good value that has been overlooked.

  • When the herd is selling a security, the market price may fall well beyond reason. Ignored, obscure, or newly created securities may similarly be or become undervalued.

  • Investors may find it difficult to act as contrarians for they can never be certain whether or when they will be proven correct. Since they are acting against the crowd, contrarians are almost always initially wrong and likely for a time to suffer paper losses. Not only are contrarians initially wrong, they may be wrong more often and for longer periods than others because market trends can continue long past any limits warranted by underlying value.

  • Conservatism and Growth Investing - How do value investors deal with the analytical necessity to predict the unpredictable? The only answer is conservatism.

How Much Margin of Safety

How can investors be certain of achieving a margin of safety?

  • By always buying at a significant discount to underlying business value and giving preference to tangible assets over intangibles. (This does not mean that there are not excellent investment opportunities in businesses with valuable intangible assets.)

  • By replacing current holdings as better bargains come along.

  • By selling when the market price of any investment comes to reflect its underlying value and by holding cash, if necessary, until other attractive investments become available.

Investors should pay attention not only to whether but also to why current holdings are undervalued. Finally, diversify your holdings and hedge when it is financially attractive to do so.

First, Avoid Losses

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.

Focus on Process, Not the Outcome

All an investor can do is follow a consistently disciplined and rigorous approach; over time the returns will come. Rather than targeting a desired rate of return, even an eminently reasonable one, investors should target risk.

Wait for the Right Pitch

  • 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 have infinite patience and are willing to wait until they are thrown a pitch they can handle-an undervalued investment opportunity.

  • For a value investor a pitch must not only be in the strike zone, it must be in his "sweet spot." Results will be best when the investor is not pressured to invest prematurely.

  • Above all, investors must always avoid swinging at bad pitches.

Reasonable & Consistent Returns > Spectacular & Volatile Returns

An investor who earns 16% annual returns over a decade will perhaps surprisingly end up with more money than an investor who earns 20% a year for 9 years and then loses 15% the tenth year.

Price vs Value

Security prices can change for any number of reasons and because it is impossible to know what expectations are reflected in any given price level, investors must look beyond security prices to underlying business value, always comparing the two as part of the investment process.

Stock Price vs Business Reality

The fact that a stock price rises does not ensure that the underlying business is doing well or that the price increase is justified by a corresponding increase in underlying value. Likewise, a price fall in and of itself does not necessarily reflect adverse business developments or value deterioration.

Complexity of Business Valuation

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.

Expecting Precision in Valuation

  • Not only is business value imprecisely knowable, it also changes over time, fluctuating with numerous macroeconomic, microeconomic, and market-related factors. So while investors at any given time cannot determine business value with precision, they must nevertheless almost continuously reassess their estimates of value in order to incorporate all known factors that could influence their appraisal.

  • 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.

Stock Market Cycles

  • All market fads come to an end. Security prices eventually become too high, supply catches up with and then exceeds demand, the top is reached, and the downward slide ensues.

  • It is only fair to note that it is not easy to distinguish an investment fad from a real business trend. Indeed, many investment fads originate in real business trends, which deserve to be reflected in stock prices.

  • The fad becomes dangerous, however, when share prices reach levels that are not supported by the conservatively appraised values of the underlying businesses.

Relevance of Temporary Price Fluctuations

  • It is, of course, not always easy for investors to distinguish temporary price volatility, related to the short-term forces of supply and demand, from price movements related to business fundamentals.

  • Indeed, investors should expect prices to fluctuate and should not invest in securities if they cannot tolerate some volatility.

  • The trick of successful investors is to sell when they want to, not when they have to.

  • The third reason long-term-oriented investors are interested in short-term price fluctuations is that Mr. Market can create very attractive opportunities to buy and sell

Overpaying for Growth

  • Investors may at times be lured into making overly optimistic projections based on temporarily robust results, thereby causing them to overpay for mediocre businesses.

  • Another difficulty with investing based on growth is that while investors tend to oversimplify growth into a single number, growth is, in fact, comprised of numerous moving parts which vary in their predictability.

  • For any particular business, for example, earnings growth can stem from increased unit sales related to predictable increases in the general population, to increased usage of a product by consumers, to increased market share, to greater penetration of a product into the population, or to price increases

Short-Term, Relative-Performance Derby

Investing without understanding the behavior of institutional investors is like driving in a foreign land without a map. You may eventually get where you are going, but the trip will certainly take longer, and you risk getting lost along the way.

How Much Research and Analysis Are Sufficient?

  • Information generally follows the well-known 80/20 rule: 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.

  • Investors frequently benefit from making investment decisions with less than perfect knowledge and are well rewarded for bearing the risk of uncertainty

  • The time other investors spend delving into the last unanswered detail may cost them the chance to buy in at prices so low that they offer a margin of safety despite the incomplete information.

An Investor’s Worst Enemy

When securities prices are steadily increasing, a value approach is usually a handicap; out-of-favor securities tend to rise less than the public's favorites. When the market becomes fully valued on its way to being overvalued, value investors again fare poorly because they sell too soon.

Don’t Seek Mr. Market’s Advice

The reality is that Mr. Market knows nothing, being the product of the collective action of thousands of buyers and sellers who themselves are not always motivated by investment fundamentals.

Prepare for the Worst

…the prudent, farsighted investor manages his or her portfolio with the knowledge that financial catastrophes can and do occur.

Shenanigans of Growth - Investors are often overly optimistic in their assessment of the future.

Stock Market ≠ Quick Money

Anyone would enjoy a quick and easy profit, and the prospect of an effortless gain incites greed in investors. Greed leads many investors to seek shortcuts to investment success.

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