Seth Klarman’s Margin of Safety is a rare and elusive book that sells for a huge premium over its
IPO original price. It’s a book about managing risk and its title is the key to it all.
Klarman follows a value investing philosophy influenced by Ben Graham — buying something for less its worth.
What’s unique about Klarman’s book is the updated views relating to his own experiences prior to publishing in 1991. There are chapters dedicated to junk bonds, institutional investing and the short-term performance race, thrift conversions, looking for catalysts, and distressed/bankrupt securities. He also covers the basic value philosophy.
I pulled eight of the bigger lessons (there are more) from the book to share. If you can get your hands on a copy, it’s worth the read.
Margin of Safety
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. It is adherence to the concept of a margin of safety that best distinguishes value investors from all others, who are not as concerned about loss.
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. Value investors invest with a margin of safety that protects them from large losses in declining markets.
If we could predict the future and act rationally at all times, a margin of safety would be pointless. Instead, investing is an imperfect game with irrational participants dealing with an unknown future. A margin of safety is a layer of protection from the imperfect.
And it protects us from ourselves. A margin of safety is the cornerstone to value investing because it leaves room for error. It helps to preserve capital from big mistakes, uncertainty, and behavioral biases that can wreak havoc on a portfolio. Simply put, the wider the margin, the more room you have to be wrong…and still not lose much.
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.
Compounding your savings at an average rate offers big advantages over time. But compounding works equally well in the opposite direction.
…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.
Losses add up. One big loss or series of losses can set you back years.
Everyone loves “spectacular gains”, that’s why chasing returns is so prevalent. Return chasers fail to recognize that “spectacular gains” are often followed by “spectacular losses.”
“Don’t lose money” does not mean never lose money. Losses are an inevitable part of the investing process. The goal is to avoid the possibility that an extreme loss wipes years’ worth of returns and a huge chunk of your portfolio.
Investors must recognize that the early success of an innovation is not a reliable indicator of its ultimate merit… At the time of issuance a new type of security will appear to add value in the same way that a new consumer product does. There is something – lower risk, higher return, greater liquidity, an imbedded put or call option to the holder or issuer, or some other wrinkle – that makes it appear superior (new and improved, if you will) to anything that came before. Although the benefits are apparent from the start, it takes longer for problems to surface. Neither cash-hungry issuers nor greedy investors necessarily analyze the performance of each financial-market innovation under every conceivable economic scenario. What appears to be new and improved today may prove to be flawed or even fallacious tomorrow.
This is true for tech innovation, but Klarman is specifically talking about financial innovation. Wall Street has a knack for chasing investing fads. Because if it works once and Wall Street can make money from it, it’ll be sold until supply exceeds demand and prices have nowhere to go but down.
It’s a process that’s repeated throughout market history. Klarman’s example is the junk bond phenomenon, which he dedicates a chapter to in the book.
In the case of junk bonds, a combination of salesmanship, bad incentives, poor math skills, and a misused academic paper drove the junk-bond boom.
The theory pushed was that junk bonds offered higher returns but with a lower risk thanks to low default rates. Yet, nobody did the basic math. When the denominator grows faster than the numerator – defaults/total issues – default rates look “safe.” The rate of new junk bond issues grew so rapidly it easily outpaced the rate of defaults.
It wasn’t until new issues slowed and ceased that the true high default rate was seen. Oversupply artificially lowered the default rate, led to the perception that a basket of junk bonds was just as safe as high-grade bonds, and everyone bought into it. But by then the damage was done. It had spilled into Savings and Loans and stock valuations.
Michael Milken and company made a killing selling new issues of “safe” junk bonds with the lure of higher yields.
Risk Is Not a Single Number
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. If an exploratory oil well proves to be a dry hole, it is called risky. If a bond defaults or a stock plunges in price, they are called risky. But if the well is a gusher, the bond matures on schedule, and the stock rallies strongly, can we say they weren’t risky when the investment was made? Not at all. The point is, in most cases no more is known about the risk of an investment after it is concluded than was known when it was made.
There are only a few things investors can do to counteract risk: diversify adequately, hedge when appropriate, and invest with a margin of safety. It is precisely because we do not and cannot know all the risks of an investment that we strive to invest at a discount. The bargain element helps to provide a cushion for when things go wrong.
Risk isn’t constant across different stocks, bonds, asset classes, or time. It has nothing to do with beta or past volatility. Risk is directly related to the price paid. Simply put, paying too high a price gives you little room for profit and a lot of room for error.
While you can never eliminate risk completely, you can reduce risk through diversification, hedging, and margin of safety. You also can unknowingly add to it by owning too much of one thing or too much of everything.
Diversification, after all, is not how many different things you own, but how different the things you do own are in the risks they entail.
Many investors insist on affixing exact values to their investments, seeking precision in an imprecise world, but business value cannot be precisely determined. Reported book value, earnings, and cash flow are, after all, only the best guesses of accountants who follow a fairly strict set of standards and practices designed more to achieve conformity than to reflect economic value. Projected results are less precise still. 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?
Any attempt to value businesses with precision will yield values that are precisely inaccurate. The problem is that it is easy to confuse the capability to make precise forecasts with the ability to make accurate ones.
The value of a business isn’t fixed. It’s not a set number. It falls in a range that changes with the performance of the business, along with interest rates, the economy, and other variables outside your control. A margin of safety protects you from unexpected changes. Reassessing value as new information comes to light does too.
Besides, prices fluctuate because opinions differ broadly, on assumptions about the future, on discount rates, on time horizons, on investment goals, on strategies…the list is endless.
Then there’s precision. Klarman blames spreadsheets for the belief that precision is possible.
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.
Leave it to finance to put too much weight on an extra decimal place. If you have to go to the hundredth or thousandth decimal place to find a valuation you like, you’ve already proven it’s not a good investment.
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. By contrast, members of the herd are nearly always right for a period. 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.
Holding a contrary 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 against the tide. It is always the consensus that the sun will rise tomorrow, but this view does not influence the outcome. By contrast, when majority opinion does affect the outcome or the odds, contrary opinion can be put to use.
The contrarian label is tossed around a lot but I doubt many people qualify for it. It goes against human nature. It requires a willingness to look wrong, a high tolerance for short-term pain, and the ability to differentiate between popular opinion and misguided opinion.
Yet, value investing is contrarian. Prices of popular stocks are bid up on optimism. Since optimistic prices leave little margin for error, value investors must look at the unloved, ignored, and obscure stocks. Then they must figure out if the stock is cheap for a reason or mispriced. It’s not for everyone.
Get Comfortable Not Knowing Everything
First, no matter how much research is performed, some information always remains elusive; investors have to learn to live with less than complete information. Second, even if an investor could know all the facts about an investment, he or she would not necessarily profit.
Most investors strive fruitlessly for certainty and precision, avoiding situations in which information is difficult to obtain. Yet high uncertainty is frequently accompanied by low prices. By the time the uncertainty is resolved, prices are likely to have risen. 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.
Klarman has an 80/20 rule for investing: the first 20% of your time will uncover 80% of the information needed to make a decision on an investment. After that, time spent getting the last 20% of information produces “diminishing marginal returns.”
In other words, by the time you learn everything, the market has figured it out, prices adjust, and you miss the biggest gains. The height of uncertainty is the hardest time to buy, which is why it’s often the best time to buy.
Since transacting at the right price is critical, trading is central to value-investment success. This does not mean that trading in and of itself is important; trading for its own sake is at best a distraction and at worst a costly digression from an intelligent and disciplined investment program. 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. If a buyer receives a bargain, it is because the seller sold for too low a price. If a buyer overpays for a security, the beneficiary is the seller, who received a price greater than underlying business value.
The best investment opportunities arise when other investors act unwisely thereby creating rewards for those who act intelligently.
Of course, the price you pay is important. Value investing is the process of buying something at a significant discount to value. The bigger the discount, the lower the risk, and the greater the possible return. That falls in line with a conservative valuation and an adequate margin of safety.
But none of it matters unless you’re comfortable with price fluctuations. Controlling your emotions is a close second. Without both, acting when prices are advantageous is nearly impossible. Emotions have a way of undermining the returns we should earn had we acted appropriately.
Unsuccessful investors are dominated by emotion. Rather than responding coolly and rationally to market fluctuations, they respond emotionally with greed and fear. We all know people who act responsibly and deliberately most of the time but go berserk when investing money. It may take them many months, even years, of hard work and disciplined savings to accumulate the money but only a few minutes to invest it…
Many unsuccessful investors regard the stock market as a way to make money without working rather than as a way to invest capital in order to earn a decent return.
This post was originally published on March 14, 2018.
Notes: Margin of Safety by Seth Klarman
Seth Klarman on Risk Management
Seth Klarman: Consistency in a Bubble
Seth Klarman: When Enron Looked Like A Steal