Klarman: Margin of Safety

TLDR

In this highly sought-after and limited value investor book, Klarman emphasizes the importance of maintaining a margin of safety, which he defines as the difference between the intrinsic value of a security and its market price. He argues that value investing requires a focus on risk management and emphasizes the need for discipline, patience, and independent thinking. Klarman also discusses the importance of avoiding fads and bubbles, maintaining a long-term perspective, and being prepared to act when opportunities arise. 

The Author

Seth Klarman is an American billionaire investor, hedge fund manager, and author known for his value investing strategy. He founded the Boston-based investment partnership, Baupost Group, in 1982 and manages $30 billion in assets. Klarman follows Benjamin Graham's investment philosophy, buying undervalued assets and seeking a margin of safety to profit from any rise in price while at the same time prioritizing the preservation of his invested capital. 

Klarman has been awarded many distinguished honors and has been called a "hedge fund titan" and "quiet giant of investing." Despite being low profile, he is often compared to Warren Buffett and referred to as the "Oracle of Boston." Buffett himself has praised Klarman's investing and reportedly keeps a copy of this book on his bookshelf. Klarman has been inducted into the Institutional Investor Alpha's Hedge Fund Manager Hall of Fame back in 2008, and Forbes listed his personal fortune at $1.5B in 2017.

Seth Klarman is a known advocate for value investing, which he recognized as his calling during his junior year in college at age 25. He believes that value investing is intellectually elegant, is supported by studies that demonstrate its effectiveness, and provides an opportunity to identify mispriced stocks in the market. Klarman subscribes to the teachings of several well-known value investors and is critical of short-term thinking in the investment industry, especially during crises. He has been successful in exploiting undervalued markets, whether in equities, junk bonds, bankruptcies, foreign bonds, or real estate. Despite his unconventional investment strategies, he has consistently achieved high returns.

His Career

Seth Klarman founded The Baupost Group with Harvard Professor William J. Poorvu, Howard H. Stevenson, Jordan Baruch, and Isaac Auerbach in 1982. The fund started with $27 million of start-up capital from the sale of Poorvu's share in a local television station. Klarman has been the CEO and portfolio manager of the Boston-based private investment partnership since its inception. Utilizing his investment philosophy, Klarman has achieved a 20% compounded return on investment since 1982. The Baupost Group raised $4 billion in capital in 2008, mainly from large foundations and Ivy League endowments. Klarman invested heavily in the equity markets after the collapse of AIG and Lehman Brothers, buying distressed securities and bonds during the financial crisis. In 2009, Klarman bought distressed credits, including the bonds of CIT Group, a financial holding company based in New York City, and FacetBiotech, a biotech company. As of 2016, the fund had $31 billion in assets under management, and in 2020, Klarman's largest holding was eBay worth $1.48 billion.

The Book

Seth Klarman's "Margin of Safety" is a book that was first published in 1991, during a time when the economy was in a state of turmoil, and many investors were struggling to make sense of the market. The renowned investor wrote this book to provide readers with a comprehensive guide to value investing, and to share his insights on risk management and successful investment strategies. During this time, institutional investors believe his wisdom was outdated, and some money managers even said Klarman has lost his edge and complained that his firm treated investors' capital like its own. Despite the naysayers, Klarman has had an impeccable investing record and this book highlights key aspects of his investing philosophy.

What He Says:

To build upon his perspective on investing and why he wrote the book, I've extracted a few key quotations from Klarman to help the reader fully understand its purpose:

    “The truth is, I am pained by the disastrous investment results experienced by great numbers of unsophisticated or undisciplined investors. If I can persuade just a few of them to avoid dangerous investment strategies and adopt sound ones that are designed to preserve and maintain their hard-earned capital, I will be satisfied.” p. XIV

    "...avoiding loss should be the primary goal of every investor." p. 93

    "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. A margin of safety is necessary because valuation is an imprecise art, the future is unpredictable, and investors are human and do make mistakes." p. 12

    "A margin of safety is necessary because valuation is an imprecise art, the future is unpredictable, and investors are human and do make mistakes." p. 12

Avoid Pitfalls

Investors are frequently enticed by the prospect of easy and quick gains and fall prey to the numerous fads on Wall Street. Value investing is a strategy that has a long history of delivering excellent investment results with minimal downside risk. Achieving investment success entails being disciplined and avoiding where others go wrong. This investment approach requires a lot of hard work, strict discipline, and a long-term investment horizon. To be successful, investors must have a level of commitment that most are unwilling to make. It is crucial for investors to distinguish stock price fluctuations from underlying business realities. Stock prices move up and down for two basic reasons: 1. to reflect business reality or the perceptions of that reality; or, 2. to reflect short-term variations in supply and demand.

The Core Philosophy

It is imperative that investors implement a margin of safety, this is critical since investing is as much an art as a science, and investors need protection against human error, bad luck, or extreme volatility in a complex, unpredictable, and rapidly changing world. This methodology will protect investors from large losses in declining markets. Value investing involves buying securities at a significant discount from their current underlying values and holding them until more of their value is realized. Utilizing this investment approach, it is important for investors to understand that stocks represent fractional ownership of underlying businesses, and bonds are also loans to those businesses. This is the type of investing value investors subscribe to, otherwise, you are a speculator. The return to owners of speculations depends exclusively on the vagaries of the resale market, and there should be no confusion as to which style is considered a true investment. 

The primary goal of every investor should be to avoid loss, which is the surest way to ensure a profitable outcome. The actual risk of a particular investment cannot be determined from historical data, and the effects of compounding even moderate returns over many years are compelling. Investors must be willing to forego some near-term return, if necessary, as an insurance premium against unexpected and unpredictable adversity. Rather than targeting a desired rate of return, investors should target risk. Treasury bills are the closest thing to a riskless investment and anything outside of this will incur higher levels of risk, but the investor must trade their risk appetite for an appropriate rate of return. Investors must always avoid swinging at bad pitches and perform valuation conservatively.

Institutional investors are often fully invested at all times, unlike value investors who take a more selective approach. This is similar to a baseball analogy, where institutional investors swing at almost every pitch, while value investors wait for the right pitch to be in their sweet spot, aka, undervalued and in their circle of competence. The key for value investors is to purchase stocks at a discount from their underlying worth and to be patient until the right investment opportunity presents itself. This can be difficult, as there are often many stocks available, but only a select few are truly valuable.

The primary goal of value investors is to avoid losing money, and there are three key elements to achieving this goal. First, value investors take a bottom-up approach, using fundamental analysis to find low-risk bargains. Second, they have an absolute performance orientation, which means they focus on achieving a positive return, rather than comparing their returns to a benchmark or index. Finally, they pay careful attention to risk, particularly the probability and amount of loss due to permanent value impairments. By using these strategies, value investors can achieve their long-term investment goals while minimizing the risk of losing money.

Proper Research

Investment research is the process of sorting through a vast amount of information to find valuable investment opportunities. It is vital to reduce the information into manageable ones and distinguish good investment ideas from bad ones. Investors should not rely on Wall Street analysts recommendations, they must put in the effort to hunt for the right opportunities on their own. Value investing can be divided into three categories: securities selling at a discount to liquidation value, rate-of-return situations, and asset-conversion opportunities. However, identifying where the most attractive opportunities are likely to arise before starting one's quest for specific investments can save time and effort. Computer-screening techniques can be useful in identifying stocks selling at a discount from liquidation value, but investors must verify that the computer output is accurate. While some investors insist on obtaining perfect knowledge about their impending investments, investors should understand that they cannot learn everything there is to know about a company, and even with complete knowledge, they may not necessarily profit. Investors should follow the well-known 80/20 rule: 80% of the available information gathered is done in the first 20% of the time. Finally, investors should take note when corporate insiders invest their money alongside shareholders by purchasing stock in the open market, as no one understands a business and its prospects better than the management.

How To Value A Company

Value investors aim to avoid losing money and seek to buy stocks at a discount to the underlying value. They use various methods of business valuation, including net present value (NPV) analysis, liquidation value analysis, and stock market value estimation. Value investors are conservative in their projections and invest only when a substantial discount is available.

NPV Analysis

NPV is the value the investor assigns to the stock which discounts all future cash flows that the business is expected to generate over a given time period. When interest rates are low, investors may face high multiples on share prices. This means they are dependent on low-interest rates, but there is no guarantee they will remain low. Therefore, investors should be cautious about committing capital to long-term holdings and instead consider holding cash or investing in short-term holdings. Value investors should value businesses based on what they would pay to own them, rather than what others would pay. There are two ways for investors to apply present-value analysis: 1. by calculating the present value of a business; or, 2. by the present value of cash flows. The latter is the best way to value bonds while analyzing the cash flows of a business is the best way to value stocks. Some investors recommend utilizing the dividend-discount method of valuation, however, it is not useful for valuing equities since dividends are only a small part of total cash flow, and predicting them far into the future is difficult. 

To accurately predict future cash flows, investors can assign probabilities to different scenarios and calculate the expected value of an investment. An analysis of cash flow captures the true economics of a business while nonrecurring gains should be ignored. It is important to mention that the appropriate discount rate for a particular investment depends on several factors, including an investor's preference for present or future consumption, their own risk profile, the perceived risk of the investment, and the returns available from alternative investments. There is no single correct discount rate for a set of future cash flows and no precise way to choose one. Taking this all into account, however, is difficult for investors to accomplish. They typically only consider a few likely scenarios and perform sensitivity analysis to evaluate the effect of different assumptions on present value. Even modest changes in assumptions can cause a significant change in net present value, so investors should exercise caution in employing this valuation method.

Liquidation Value Analysis

The liquidation value of a business is a conservative assessment of its worth based solely on tangible assets, while intangibles, such as going-concern value, are not considered. Although liquidation analysis is a theoretical exercise in valuation, it is not typically an actual approach to value realization. This is because the assets of a company are generally worth more as part of a going concern than in liquidation. When a stock is selling at a discount to the liquidation value per share, it is often considered an attractive investment. Even when a company has little ongoing business value, investors who buy at a price below net-net working capital are protected by the approximate liquidation value of current assets alone.

Breakup value is one form of liquidation analysis, which involves determining the highest value of each component of a business. In an orderly liquidation, the values realized from disposing of current assets will more closely approximate the stated book value. It is important to note that the value of inventories can be difficult to determine, depending on factors such as whether they consist of finished goods, work in process, or raw materials. The liquidation value of a company's fixed assets can also be challenging to calculate. Investors must always consider the state of a company's current operations before buying, as ongoing business losses can quickly erode net-net working capital. Contingent liabilities, such as underfunded pension plans, should also be considered. Although liquidation is often associated with business failure, it may correspond with investment success because it is a catalyst for the realization of underlying business value and realizing profits.

Stock Market Value Estimation

In certain circumstances, investors have no choice but to rely on public equity and debt markets to determine the value of a security. For instance, the stock market method may be the best available method of valuation when a closed-end mutual fund is in question. In such cases, the stock market value, which is the price at which holdings can be sold immediately in the stock market, provides the most relevant measure of the liquidation value. While the stock market's vote may not always be accurate, it is a near-term appraisal of value. Moreover, when attempting to value a company's interest in an unrelated subsidiary or joint venture, investors benefit from considering the stock market value, along with discounted anticipated future cash flow stream, private-market value, and liquidation value. The stock market value is just one of several valuation tools and provides a yardstick of what a security, not a business, might fetch if sold immediately. However, using stock market value to appraise each company in an industry would be circular reasoning. Knowing the stock market's appraisal of an industry could aid in estimating the near-term trading price of a subsidiary about to be spun off to the shareholders of a media conglomerate.

Taking all of the above methods into account, the appropriate method of valuation depends on the type of business. NPV analysis is best for high-return businesses with stable cash flows, while liquidation analysis is appropriate for unprofitable businesses trading below book value. Closed-end funds or other companies that own only marketable securities should be valued by the stock market method. In some cases, multiple methods may be needed, such as when valuing a conglomerate with several distinct businesses. In such situations, investors may want to adopt lower values over higher ones to err on the side of caution. While conservatism may prevent investors from taking some successful investments, it could also help avoid significant losses resulting from less conservative valuations.

Managing The Position

Trading and portfolio management are essential components of investing. An investor's decision to buy or sell securities can significantly impact their investment returns. Good trading decisions can boost profitability, while poor decisions can result in missed opportunities. Portfolio management involves regularly reviewing one's holdings, maintaining appropriate diversification, making hedging decisions, and managing cash flow and liquidity.

Investors must accept that the investment process is continuous, and portfolio management is ongoing. Although specific investments have a beginning and an end, portfolio management never ends. There is no certainty of profitable business or backlog of upcoming investment returns. Investors should be open to changing their minds, and selling stocks before an anticipated event can lead to minor financial consequences if the investor determines their hypothesis was incorrect. 

A completely liquid portfolio can guarantee no loss, but it also eliminates the possibility of earning a high return. Investors must find the right balance between seeking returns and limiting risks. The appropriate balance between illiquidity and liquidity is never easy to determine. However, holding onto illiquid investments without demanding compensation for bearing the illiquidity risk often leads to regret. Diversification is crucial to reducing portfolio risk, and as few as ten to fifteen different holdings can usually suffice. However, diversification for its own sake is not sensible. Market risk can be a major concern for investors, and diversification alone cannot reduce it. Hedging strategies can limit market risk, but the investor's choice among the possible hedging strategies depends on the nature of their holdings. Despite this, investors should be willing to incur risk and remain unhedged when the available return is sufficient.

Time has shown that the best investment opportunities arise when other investors act unwisely, creating rewards for those who act intelligently. Trading involves taking advantage of such mispricings. The single most crucial factor in trading is developing the appropriate reaction to price fluctuations. Investors must resist the tendency to panic when prices are falling and to become overly enthusiastic when prices are rising.

Investors should refrain from purchasing a "full position" in a security all at once. Buying a partial position leaves reserves that permit investors to "average down" their average cost per share if prices decline. Evaluating their willingness to average down can help investors distinguish prospective investments from speculations. Investors should avoid potential investments in poorly managed companies, highly leveraged businesses, unattractive businesses, or companies beyond their understanding.

Knowing when to sell can be the hardest decision for many investors. It is challenging to determine precisely what an investment is worth, and investors often buy with a range of values in mind. Investors should sell when the price is above their estimate of the investment's intrinsic value or if they find a more attractive opportunity elsewhere. Investors should be disciplined in their selling decisions and avoid holding on to investments in the hope of recouping losses.

In summary, trading and portfolio management are crucial components of investing. Investors must find the appropriate balance between illiquidity and liquidity, seek diversification, and be willing to incur risk when returns are sufficient. The key to successful trading is developing the appropriate reaction to price fluctuations, and investors should avoid purchasing a full position all at once. Lastly, investors must be disciplined in their selling decisions and avoid holding onto investments beyond their intrinsic value.