Margin of Safety by Seth Klarman

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Seth Klarman’s rare classic is about managing risk. Borrowing Ben Graham’s primary concept for the title, the book teaches how to think about the value investing philosophy and why it works.

The Notes

• Value investing has a long record of excellent returns with limited downside risk.
• It’s a book about how to think about investing — you have to understand why value investing works. It’s not enough to know the rules behind it, but understand why the rules work, when they work, and when they don’t.
• Wall Street Misbehavior: short term focused, driven by the volume of activity, ignorant of business fundamentals, casino operator, pushing index strategies designed to avoid volatility at the cost of mediocre returns.
• Institutional Investor Misbehavior: short term focused, driven by performance pressure, compensation, and career risk, which pushes relative performance and fad chasing.
• Investors Misbehavior: they are their own worst enemies — greed, fear, and other emotions cause investors to ignore fundamentals when making decisions.
• Misbehavior creates opportunities for value investors.
• Price versus Value example: “Disregarding for the moment whether the prevailing level of stock prices on January 1, 1987 was logical, we are certain that the value of American industry in the aggregate had not increased by 44% as of August 25. Similarly, it is highly unlikely that the value of American industry declined by 23% on a single day, October 19.” — Ruane and Cunniff on 1987.
• You can treat stocks as pieces of paper to be traded based on guessing its next price move or you can treat stocks as ownership in a business.
• The greatest challenge is patience and discipline.
• Investors profit by:
  1. Free cash flow made by the business.
  2. Increase in the multiple paid that’s reflected in the share price.
  3. Share price moves closer to the value of the business.
• Speculation:
  • Trading Sardines versus Eating Sardines: The story goes that sardines once thrived off the coast of Monterey, California until one day they disappeared. The commodity traders bid up the price of sardines and canned sardine prices soared. One day, a commodity trader helped himself to a can, opened it, and began eating. He quickly got sick. The sardines were no good. To which his friend replied, “These are not eating sardines, they are trading sardines.”
  • Speculation can erupt anytime, anywhere, and not be recognized until much later, and after much money has been invested and lost.
  • Driven by instant gratification: getting rich quickly is more appealing than getting rich slowly.
  • Greater Fool Game: buying a stock with the hopes a greater fool will quickly take it off your hands at a higher price.
  • Lazy Game: requires no analysis or information about the business. It’s guessing what other investors will do, and try to do it first.
  • Collectibles are a speculative game since prices are driven by taste, not free cash flows.
• Winchester Disk Drive Mania:
  • 43 Winchester disk driver manufacturers received venture funding between 1977 and 1984.
  • By mid-1983, 12 of the publicly traded manufacturers of disk drives were valued at $5 billion in total.
  • There was no chance all 12, much less 43, would dominate the market — only a few might survive. Nor would the market be remotely worth $5 billion in the future (based on a study done in 1983).
  • By 1984, the total market of the 12 public companies was down to $1.5 billion.
• Mr. Market: is a helpful fellow. Every day he’s ready to buy or sell securities at a price he set that minute. Sometimes the prices are reasonable. Sometimes, emotion gets the best of him. He becomes optimistic or pessimistic and his prices reflect it. If you look to Mr. Market for guidance, thinking his prices hold meaning, it can lead to speculation and loss. Beware: Mr. Market’s prices hold no hidden meaning. He knows nothing. It’s only the collective action of millions of buyers and sellers whose actions aren’t always motivated by fundamentals. You can take advantage of Mr. Market’s frequent emotional moments or do nothing. It’s your choice.
• Why security prices move (up and down):
  1. To reflect reality or changes in perception of reality.
  2. Short term changes in supply and demand.
• Not all market selloffs are buying opportunity.
• Wall Street has a bullish bias. An optimistic case can be made for any security, and often is made. It’s also more enjoyable for management and investors to hear the optimistic view. But a focus on optimistic outcomes comes with a cost of ignoring risk.
• “Since security prices reflect investors’ perception of reality and not necessarily reality itself, overvaluation may persist for a long time.”
• Financial Innovation: early success does not equate to being good. It often looks better early on, but the merits of any financial innovation must be determined over the course of a full market cycle. Problems often take time to surface. What’s lauded as a new improved way to invest is really just a fad — one that could be taken to an extreme.
• Investment Fads: investors slap optimistic growth numbers on new technology, products, etc. that don’t fit reality. Unsustainable multiples are the end result. Market history is filled with optimistic fads that failed to live up to expectations and came to an abrupt end. The cycle of fads is a byproduct of investor behavior and unlikely to end.
• Career Risk: some fund managers invest to protect their jobs which can lead to groupthink, herd mentality, and mediocre returns closer to their benchmark (and underperform after fees). Because the risk of trying to earn the best return possible over the long run comes with the risk of underperformance, that might not sit well with investors. It leads to a short-term relative performance bias.
• Be wary of fund managers who don’t (won’t) invest their own money in funds they run.
•  To be fully invested or not should depend on the number of available opportunities. Doing nothing — not being fully invested — is a smart option when opportunities are lacking.
• Why understand institutional investors?
  1. They dominate the market, so their behavior has a big impact on markets.
  2. Institutional investors are often too big to invest in certain areas of the market that, in turn, offer rewarding opportunities for smaller investors.
• Junk Bond Mania:
  • Junk bonds were sold as a new innovation in the 1980s that took on manic proportions. Initially hailed as “safe” investments but by 1990 defaults hit record levels.
  • W. Braddock Hickman showed, via a study, that a portfolio of low quality, high yield bonds could outperform a high-quality bond portfolio. The higher rates more than compensated for defaults and losses. It worked because enough investors avoided low-quality bonds, causing depressed prices. Price appreciation, not yields, was behind the better return. The real opportunity was in bonds priced to default — fallen angels selling well below par — which then improved and recovered.
  • Milken took the idea that high-yield bonds outperformed, pushed it excess, but left out the important point of depressed prices.
  • Milken claimed low-rated bonds earned a historically higher return than highly-rated bonds. He also claimed that the risk was low because losses from defaults were easily compensated by higher yields. And he claimed liquidity wouldn’t be a problem.
  • Unlike fallen angels selling below par, Milken’s newly issued junk bonds were sold at par value. There was no chance of price appreciation. They were already priced for perfection (survival). New junk bonds came onto the market with limited upside and a big risk of default and loss.
  • Because junk bonds were a new concept, the default rate was deceptively low for two reasons: defaults can take time and the number of defaults lagged behind the number of junk bond issuances — the denominator (# of junk bond issuances) outgrew the numerator (# of defaults). The true default rate was only uncovered once new issues slowed and ceased.
  • The deceptively low default rate was used to promote the “junk bonds are safe” narrative. High yields for little or no risk become a big selling point that quickly caught on. The high demand allowed junk bonds to be issued by virtually anyone looking to borrow money, from unsound small businesses in need of debt to corporate takeovers artists.
  • A study on the interest coverage ratio of newly issued junk bonds had fallen to below 1 by 1988. Pretax earnings were less than the interest expense on new issues. Debt to net assets tripled over the same period.
  • Newly created high-yield bond funds helped drive demand and forced their competition, which held higher-quality bonds, to swap high-quality for high-yield in order to compete.
  • A few thrifts (S&Ls) used junk bonds, along with other risky assets, to offer a higher interest rate on accounts and grow their deposits, but it ultimately led to their insolvency and the S&L crisis.
  • Interest rate resets became a widely used feature on junk bonds — it’s a promise that the issuer will reset the coupon at a specific date to cause it to trade around a specific price.
  • EBITDA became the proxy for free cash flow when valuing highly leveraged businesses. Which led to flawed analysis and overvaluation. If interest is large enough, like it was at the time, no earnings would exist.
• “If a historically accepted investment yardstick proves to be overly restrictive, the path of least resistance is to invent a new standard.”
• Avoiding loss should be the first goal. That does not mean no losses of any kind. A portfolio, over time, should not be exposed to the chance of significant losses.
• A loss avoidance strategy is not about having a fixed allocation to certain securities or having a fixed return goal to meet. It’s about knowing that unexpected things happen, risks always change, so you have to be prepared for that eventuality.
• Risk depends on the price paid for a security.
• “the effects of compounding even moderate returns over many years are compelling, if not downright mind-boggling.”
• Compounding requires perseverance in order to succeed. It’s important to avoid extreme losses since it can quickly wipe out years of compounding that has built up.
• “Investors intent on avoiding loss consequently must position themselves to survive and even prosper under any circumstances.”
• Because the future is unpredictable, it’s impossible to know what markets will do next. Or the economy. Or interest rates. Bad luck, mistakes, rare catastrophes, and crises do happen. Investors need to be prepared for when these unexpected surprises happen again.
• Value investing is buying dollars for 50 cents — buying securities at a discount to their underlying value. It combines a conservative value analysis with the discipline to only buy when a discount to value is significant.
• Buffett’s baseball analogy: Investors have no called strikes. Nobody’s keeping track of the number of pitches you see. You don’t have to swing at any pitch (investments). You can patiently stand at the plate with the bat on your shoulder, waiting for the perfect pitches — the ones you’re most comfortable with, that you understand the most.
• New investments must be weighed against other available opportunities and existing holdings. It ensures that your portfolio is always made up of the best opportunities. That means no investment is sacred, especially if a better one comes along.
• Be comfortable with imperfect information because you’ll never know everything about an investment. And if you did know everything, then the opportunity is likely gone because the market already priced it in.
• Ways to protect from declining business values:
  • Always do conservative valuations, with the worst-case scenario or liquidation value in mind.
  • Require a wider margin of safety — a deeper discount to fair value — to account for risks like deflation that lower the value of an investment.
  • Catalysts, that offer a time frame to realize value, help offset uncertainty that comes with the typical unknown time horizon for most investments.
• Margin of Safety:
  • allows for imperfection, error, bad luck, or excessive volatility in order to avoid big losses.
  • The difference between price and fair value is your margin of safety. The wider the difference, the wider margin, the more protected you are from surprises.
  • Preservation of capital is built-in and necessary because valuation is imperfect, the future is unpredictable, and people make mistakes.
  • Margin of safety can be improved by replacing a current holding with better opportunities, selling once value is mostly realized, and holding cash when no significant bargains exist.
• It’s important to know why an investment is undervalued and to sell when it no longer applies.
• Look for management that puts their own money at risk in the business.
• Bear markets are the real test of an investment philosophy.
• In market declines, stocks are often priced as if nothing can go right. They have the widest margin of safety and the lowest amount of risk because the worst-case scenario is priced in. They also have the highest upside. When focus and expectations shift from the worst-case to the strength of business fundamentals, the market will send prices higher.
• Value investing is:
  • Based on bottom-up analysis – it makes it easier to know when the reason why behind an investment no longer applies.
  • Absolute over relative performance – allows investments to be judged on their own merits, while not worrying about what the market is doing in the short term.
  • Focused on what can go wrong over what can go right – keeps risk front of mind and helps to avoid losses.
• “In investing it is never wrong to change your mind. It is only wrong to change your mind and do nothing about it.”
• Risk can’t be reduced to a number. Risk is weighed by imperfect analysis — the probability and amount of potential loss for any investment include unknowns. It’s why a margin of safety, diversification, and hedging are important.
• “The trick of successful investors is to sell when they want to, not when they have to.”
• Opportunity Cost: Build a portfolio with opportunity cost in mind. Holding some cash or securities that throw off cash in a portfolio helps offset opportunity costs. Investments with catalysts, like risk-arbitrage, tend to be short term in nature which also helps as investments are sold for cash plus profits.
• Business Valuation:
  • “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.”
  • Business valuation is an art. It’s imperfect. It changes with micro- and macroeconomic changes. Assumptions of future cash flows can be made down to the penny. Just because you can discount future cash flows out to the nth decimal place doesn’t make the calculation precise or accurate.
  • Ben Graham sought to find a valuation that is adequate.
  • “The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security. It needs only to establish that the value is adequate – e.g., to protect a bond or to justify a stock purchase – or else that the value is considerably higher or considerably lower than the market price. For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient.” — Ben Graham
  • Markets are the collective result of a difference of opinion. Buyers place the value of a security higher than what they paid. Sellers put the value lower than they’re selling price. They both feel they’re getting a deal. The buyer and seller likely differ on their assumptions of the future cash flows, the discount rate, etc. leading to a range in valuation. The true value likely falls somewhere in between.
  • Discount future cash flows (NPV analysis) can be a very accurate valuation method. But…less than certain cash flows, inaccurate growth forecasts, and arbitrary discount rates can be problematic and imprecise.
  • “Small changes in either revenues or expenses cause far greater percentage changes in profits. The number of things that can go wrong greatly exceeds the number that can go right.”
  • More stable businesses tend to be more predictable (not always) but the predictability means it’s less likely to be selling at a deep discount.
  • Many factors go into a business’s growth, making it difficult to predict — unit sales, population growth, product usage, market share, price increase…
  • Biases — optimism or pessimism — influencing the numbers will throw the valuation further off. Too much optimism in projections could mean that everything has to go right for the projections to work out or losses are certain.
  • Conservative assumptions are the only solution to the problem of inaccurate valuations. Then invest at a discount to the conservative valuation.
  • There is no correct discount rate — it depends on: the investor’s risk profile, the riskiness of the investment, and alternative investment options.
  • The dividend discount method can ignore a large percentage of total cash flows and projecting dividends far into the future often ignores the chance of cuts or accuracy in predicting raises.
  • Private market valuation – must ignore inflated prices paid in takeovers when using private market valuation.
  • Liquidation Value (net-net working capital) — current assets minus current and long-term liabilities. Offers protection — worst-case scenario — if bought below liquation value. Beware of operations that can quickly burn through current assets, underfunded pensions, environmental laws around plant closings, etc.
  • Relative valuation: is a yardstick for assessing how the market values businesses in a similar industry today. Useful in assessing how the market might value a subsidiary or spinoff.
  • Which valuation method to use? It depends on the situation.
  • Earnings per share is imprecise, hard to project, and can be manipulated. Nonrecurring earnings (one-time items) should be ignored as it inflates earnings. Earnings (or cash flow) is just one way to understand what’s going on inside a business.
  • Book value can be imprecise depending on the asset in question. Current assets are generally accurately valued. Building, plant, and equipment may not be. Outside factors like inflation, technology innovation, regulation can affect asset value too that can’t be easily assessed — not always negatively. Regulations may introduce scarcity making an old plant more valuable due to the higher cost of building a new one. Book value is only one piece in an analysis.
  • Dividend yield can be deceptive. A high yield might look attractive but is likely the result of a fallen stock price…with a potential dividend cut priced in. The company’s ability to survive a prolonged downturn and pay a dividend needs to assessed along with yield.
• Theory of Reflexivity — stock price can influence business value:
  • When a business needs additional capital, stock price determines its success. With a high stock price, built on optimism, the market might see new share issuance as a positive. Whereas with a low stock price, a new issuance might be viewed negatively or not be possible.
  • When management sees stock prices, not fundamentals, determine valuation.
  • Reflexivity is a wild card — occasionally very important.
• Value Investing Niches:
  • Discount to Liquidation Value — net-net working capital.
  • Rate-of-Return Situations: where time frame and exit prices are more predictable — risk arbitrage around mergers, tender offers, etc. where a catalyst is involved.
  • Asset Conversions: distressed debt, bankruptcies, recapitalization, and exchange offers.
• It’s important that investors figure out why a bargain became a bargain. Ask: What’s wrong with it? What are the flaws? The reason may help decide how predictable the outcome is and whether its a better or worse investment because of it.
• Value investing is contrarian, investing against the herd, avoiding what’s popular, searching for the ignored and unloved securities. Because of this, value investors almost always look wrong and experience paper losses at first — get used to it. Eventually, opinions and trends change, the unloved become loved, and security prices rise to fair value.
• “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.”
• Fundamental analysis is subject to diminishing returns.
• The 80/20 rule: 80% of available information is found in the first 20% of the time spent searching.
• Low prices come with high uncertainty. Waiting for perfect information leads to missed opportunities (once all information is available, prices have risen). Investors buying at low prices in uncertain times, often do so at a wider margin of safety, that provides protection from the added risk of uncertainty, and still get rewarded.
• Buying along with insiders can be profitable. Watch for insider buying, with their own money, in the open market. Insiders have many reasons to sell, but only one reason to buy.
• Catalysts help reduce risk. Since catalysts come with a defined time frame, value realization happens quicker and lowers the chance of loss in the process.
• Catalysts for total value realization: liquation or sale of the business.
• Catalysts for partial value realization: spinoffs, recapitalizations, buybacks, asset sales.
• “As with any value investment, the greater the undervaluation, the greater the margin of safety to investors.”
• Complex Securities: securities with unusual contractual cash flow characteristics tied to a contingent event. Often rare, unusual, and hard to evaluate, which leads investors to avoid entirely, limiting demand and creating value. Klarman gives several examples:  participation certificates, certain preferred stock with unusual features, contingent-value rights, and rights offerings.
• Risk Arbitrage: gain/loss depends on the completion of a takeover deal. Returns are determined by the spread between the price paid and the amount paid on completion of the deal. The downside is the transaction or deal fails. Goes through periods of popularity. Periods of high uncertainty can make risk arbitrage opportunities attractive.
• All investment philosophies and niche strategies go through a cycle of popularity. When a strategy becomes popular, it sees more money flow in, increases buying, higher prices, and reduces future returns. A period of poor returns sees money outflows, prices fall, popularity wanes, and raises future returns.
• Spinoffs result when a parent company distributes shares in a subsidiary to its existing shareholder. It’s often an attempt by management to unlock value — where the parts are greater than the combined business. Spinoffs can be underfollowed, often small-caps, that are quickly sold by existing shareholders for a number of reasons. It can lead to undervalued opportunities in the spinoff or the parent company.
• “A simple rule applies: if you don’t quickly comprehend what a company is doing, then management probably doesn’t either.”
• A conservative valuation is more important in highly leveraged businesses.
• “…the herd mentality of investors can cause all companies in an out-of-favor industry, however disparate, to be tarred with the same brush.”
• Distressed/Bankrupt Securities: difficult to analyze and come with a stigma around bankruptcy that keeps most investors out of these securities. It creates attractive opportunities with debt selling way below par. Companies that file for bankruptcy have hit bottom — nowhere to go but up, once lenders are satisfied and new financing becomes available. But it requires caution. Not all companies recover to their former glory.
• Financial Distress Scenarios (must consider the possibility of each):
  • Continue payment of principal and interest.
  • Exchange new securities for those outstanding.
  • Default and file for bankruptcy.
  • (Cost-cutting, asset sales, or outside capital are other short-term options considered by management before the above scenarios. It can lead to a worsening of the long term business value.)
• Bondholders, unlike shareholders, can’t be forced to go along with an exchange offer or other deal by the majority of bondholders who agree to it. There’s an upside and downside in holding out — like the Prisoner’s Dilemma. Often creditors will agree to a plan in advance of bankruptcy.
• Senior securities, during a bankruptcy, often move independent of the market, since it’s tied to the progress of the reorganization.
• Three Stages of Bankruptcy:
  • After Chapter 11 filing: highest uncertainty, lowest information, greatest opportunity (if it exists) — the financial situation is uncertain, financial statements missing/late, liabilities are not obvious, securities prices highly volatile, and debt holders may be forced to sell.
  • Negotiation of reorganization plan: months to years to reach this point — the financial situation is known but uncertainty exists around the plan and how each creditor class will fair.
  • Finalization of a plan and emerging from bankruptcy: takes three months to a year — closer to a risk-arbitrage dependent on final approval, plan being contested or rejected by a creditor or plan falls through.
• Financial Distressed Securities: requires patience, returns are dependent on timing, often illiquid, price must be the primary focus.
• “In an illiquid market the price at which a security transaction takes place is determined not so much by investment fundamentals as by the trading savvy of the participants. In the illiquid market for distressed and bankrupt bonds, being a smart trader may sometimes be more important than being a smart analyst.”
• Financial Distress Valuation:
  • Starts with valuing the assets, split into two groups — current assets (cash, investment securities, assets held for sale) and assets of the operating business.
  • Account for any income statement or cash flow distortions like interest expense not being paid, costs of Chapter 11, etc. that will or won’t exist once out of bankruptcy.
  • Look at off-balance sheet assets — real estate carried below value, pension fund, patents, claims owed to IRS, EPA, PBGC, etc.
  • Analyze liabilities in descending order — may find opportunities at each level of debt structure, senior debt being less risky, junior debt offering greater returns but a higher risk of loss. Common stock should be avoided.
• “All investors must come to terms with the relentless continuity of the investment process. Although specific investments have a beginning and an end, portfolio management goes on forever.”
• “Since no investor is infallible and no investment is perfect, there is considerable merit in being able to change one’s mind.”
• Duration must be assessed with liquidity risk. Investors should be compensated more for the risk of holding an illiquid investment over a longer period of time.
• “In the stock market, there is liquidity for the individual but not for the whole community. The distributable profits of a company are the only rewards for the community.” — Louis Lowenstein, What’s Wrong with Wall Street
• Liquidity is dependent on the availability of buyers and sellers. Liquidity is prevalent in normal markets, non-existent in panics.
• Finding the right balance for a portfolio between liquidity and illiquidity, low risk and high risk, low return and high return can be tricky.
• A portfolio with systematic liquation or cash flows built-in – via dividends or sales — can help avoid complacency and add a challenge of always looking for best available bargains.
• Portfolio management should be about risk reduction. Reducing risk at the portfolio level, while accounting for risk in individual investments.
• There’s a fine line between diversification and over-diversification. 10-15 holdings is enough for Klarman.
• “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.”
• Market risk can be limited by hedging, but can also be costly.
• Opportunity is a function of price.
• “The best investment opportunities arise when other investors act unwisely thereby creating rewards for those who act intelligently.”
• Klarman recommends buying partial positions and averaging down if price declines. If your analysis is good, you should want to own more at a lower price.
• Selling is the hardest part:
  • Since valuation is imperfect, knowing what price to sell at is also imperfect.
  • “There is only one valid rule for selling: all investments are for sale at the right price.”
  • Should be based on underlying value, alternative opportunities, liquidity.
• “Returns must always be examined in the context of risk.”
• Probabilities allow for the possibility of luck in investment returns. It’s up to investors to assess past success — their’s and fund managers’ — to luck or skill. Hopefully, done so humbly and objectively.
• Poor returns might be due to a bad strategy, bad luck, or an out of favor strategy, soon to be in favor, thanks to mean reversion.

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