Margin of Safety a Book by Seth Klarman

A Summary of Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor

Introduction to an Investing Classic:

“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.” -Seth Klarman, page xiv

In 1991 Seth Klarman published “Margin of Safety, Risk-Averse Value Investing Strategies for the Thoughtful Investor.” Today investors have unwittingly dismissed his wisdom as out of touch, much like they did in 1999. As owners of one of the 5,000 copies in circulation, we believe this is a worthwhile moment to revisit his text.

Those who own Seth Klarman’s book will find our brief notes wildly inferior to the actual book. Certainly we agree. Fortunately our goal is modest. If our notes inspire prudence in one speculator we will exceed the break even point of our efforts.

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A Margin of Safety Formula:

We understand the desire for quick profits and a simple formula. In our experience, reading and implementing the wisdom on offer from the most accomplished investors is the formula. Over the last several months, we have been relentless in pointing our readers to the wisdom of Warren Buffett. As we documented in this QTFC, Buffett has been pilloried by the press today as he was in 1999.

Institutional Investor published an article discussing how some allocators felt Seth Klarman had lost his edge. One of the complaints was that the firm treats investors’ capital like its own. We believe this thinking is typical of euphoric speculative markets like today.

How does one calculate the margin of safety? Buying below the intrinsic value of a stock to mitigate the risk of losses sounds simple. Yet, as evidenced by today, doing nothing due to a lack of attractive opportunities while the stock market soars is painfully difficult.

Some Quick Lessons from Mr. Klarman’s Margin of Safety Book:

Introduction:

Quote: Investors adopt many different approaches that offer little or no real prospect of long-term success and a considerable chance of substantial economic loss. –page xiii

• Reading and studying how others lost money will save you a lot of money
• Warren Buffett knows what he is doing, read, learn and prosper
• You must invest against fads and conflicted advice from Wall Street to grow capital safely
• Manias frequently happen as groupthink ricochets from fear to greed
• Buying assets for less than they are worth becomes mechanical as the process works over time

Chapter 1: Speculators and Unsuccessful Investors

Quote: Mark Twain said that there are two times in a man’s life when he should not speculate: when he can’t afford it and when he can. –page 3

• Investing is the act of viewing a share of stock as an interest in a company
• You must then ask “do I want to own this company?” and “am I paying less than fair value?”
• Speculative activity breaks out frequently and sucks in even the most responsible savers
• Chasing yield is dangerous
• Speculating is easy because you are going with the crowd
• Investing is difficult because you must be disciplined and invest where the crowds are not

Chapter 2: The Nature of Wall Street Works Against Investors

Quote: Investors even remotely tempted to buy new issues must ask themselves how they could possibly fare well when a savvy issuer and greedy underwriter are on the opposite side of every underwriting. … The deck is almost always stacked against the buyers. –page 22

• Remember, Wall Street gets paid on how much they do, but not if what they are doing makes you money
• IPOs are for suckers so don’t be a sucker
• If you are investing in something that is popular and making headlines it is probably a fad
• Fads always end badly
• Please do not invest in fads

Chapter 3: The Institutional Performance Derby: The Client Is The Loser

Quote: It is worth noting that few institutional money managers invest their own money along with their clients’ funds. The failure to do so frees these managers to single-mindedly pursue their firms’, rather than their clients’, best interests. –page 40

• Pursuing short term relative returns could be a failure of the “prudent man” rule
• Career risk drives many professional managers to chase fads out of fear of losing their jobs
• All human beings can fall prey to the lure of apparently quick profits
• Indexing is mindless and tends to grow in popularity during bull markets

Chapter 4: Delusions of Value: The Myths and Misconceptions of Junk Bonds in the 1980s

Quote: The greed and possibly the ignorance of individual investors, the short-term orientation of institutional investors, and the tendency of Wall Street to maximize its self-interest above all came together in the 1980s to allow a $200 billion market to develop virtually from scratch. Although unproven over a complete economic cycle, newly issued junk bonds were hailed as a safe investment…. –page 55

• Buying bonds for price appreciation instead of income can be a terrible idea
• The appetite for lending to financially weak firms is cyclical
• Lenders go from offering too much money at poor terms to offering zero money at any terms
• Lending a lot of money to firms of weak to negligible creditworthiness will not fix America’s problems
• EBITDA is a terrible measure of valuation and a terrible proxy for free cash flow
• When historical methods of valuation can’t justify stock prices, Wall Street invents new ones that inevitably fail

Chapter 5: Defining Your Investment Goals

Quote: The speculative urge that lies within most of us is strong; the prospect of a free lunch can be compelling, especially when others have already seemingly partaken. –page 81

• If the market is on a manic run there is no harm in holding some cash
• The break even analysis on cash is easy
• Compounding at lower rates with smaller losses is better than at larger rates and higher losses
• Forecasting macroeconomic outcomes is comically difficult
• Investing with the understanding that negative outcomes are possible is the duty of all value managers

Chapter 6: Value Investing: The Importance of a Margin of Safety

Quote: Value investing combines the conservative analysis of underlying value with the requisite discipline and patience to buy only when a sufficient discount from that value is available. –page 87

• Value investing can be a painful and solitary endeavor
• This is particularly true when markets are expensive for long periods of time and value investors suffer
• The price you pay for an asset is the arbiter of “do you have a margin of safety”
• Be conservative when assessing asset values to help ensure there is a margin of safety
• IPOs and securities built with financial “innovation” create a “margin of peril”
• “Value pretenders” embrace narratives based on forecasts and should be avoided

Chapter 7: At the Root of a Value-Investment Philosophy

Quote: …a great many professional investors employ a top-down approach. This involves making a prediction about the future, ascertaining its investment implications, and then acting upon them. This approach is difficult and risky, being vulnerable to error at every step. –page 105

• Top-down investors are playing a difficult game that offers zero margin of safety
• Value investors operate one security at a time, seeking a margin of safety by finding bargains
• Cash generating assets help reduce the risk and shorten portfolio duration
• Beta, the volatility of stock price movements, is not a measure of risk
• The primary goal of a value investor is the preservation of capital
• Buying at discounts to conservative estimates of value underpins the humble admission we cannot predict the future

Chapter 8: The Art of Business Valuation

Quote: A recurring theme in this book is that the future is not predictable, except within fairly wide boundaries. … Yet several difficulties confront growth-oriented investors. First such investors frequently demonstrate higher confidence in their ability to predict the future than is warranted. –page 123

• Future business results are volatile so depending on precision forecasts is risky
• Paying too high a price for even the best companies wipes out even perfect execution over many years
• During periods of unusually low interest rates, securities of all types tend to trade at high prices
• Value investors should be particularly careful during periods of unusually low rates
• The information value of private markets can be low when credit is cheap, conditions are lax, and share prices are inflated
• The liquidation value of a business is a conservative assessment of its worth
• Looking at peers is not a method of estimating conservative value but is a healthy safety check

Chapter 9: Investment Research: The Challenge of Finding Attractive Investments

Quote: While knowing how to value businesses is essential for investment success, the first and perhaps most important step in the investment process is knowing where to look for opportunities. –page 151

• Without a disciplined process, investors will spend most of their time looking at fairly valued securities
• What is unpopular is more likely to be undervalued and popular stocks are almost never cheap
• Skillful value investing requires operating with imperfect information
• The pursuit of every last fact can cause investors to miss opportunities without any benefit
• Insider selling is not particularly valuable, but insider buying is worth watching

Chapter 10: Areas of Opportunity for Value Investors: Catalysts, Market Inefficiencies, and Institutional Constraints

Quote: The securities of high-return businesses therefore reach compelling levels of undervaluation only infrequently. –page 162

• Companies where things are going great are easy to spot
• Investors tend to ascribe high hopes to the future of such firms
• These high hopes elevate valuations and wipes out an adequate margin of safety
• Catalysts reduce the time (and risk) until the realization of intrinsic value for value investors
• Liquidations, complex securities, rights offerings, and spin-offs are all fertile grounds for finding value

Chapter 11: Investment in Thrift Conversions

Quote: Thrift conversions … [can] … illustrate the way the herd mentality of investors can cause all companies in an out-of-favor industry, however disparate, to be tarred with the same brush. –page 188

Due to the highly specialized nature of the language and specific example used we believe there is a simple takeaway. Mispriced securities with a margin of safety embedded in the price are often in sectors that are out of favor.

Chapter 12: Investing in Financially Distressed and Bankrupt Securities

Quote: Because most investors are unable to analyze these securities and unwilling to invest in them, the securities of financially distressed and bankrupt companies can provide attractive value-investment opportunities. –page 190

• Firms in severe financial distress frighten investors and can be excellent places for value investors
• Wide variations between how bond and equity investors are pricing a firm can signal opportunity
• Despite the complexity of investing during the bankruptcy process, even this area can become popular and overpriced

Chapter 13: Portfolio Management and Trading

Quote: Today with so many market participants having little or no fundamental knowledge of the businesses their investments represent, opportunities to buy and sell seem to present themselves at a rapid pace. –page 216

• The price paid rather than the progression of fundamentals often determines the returns to owning firms in stable businesses
• Liquidity and fads are highly correlated
• What is liquid and popular today can become illiquid quickly
• While diversification is an essential part of reducing downside risk, hedging serves a valuable purpose
• Be aware of what factors affect your portfolio and hedge out risks, like duration, if possible
• Always leave room to average down as cheap assets can become cheaper

Chapter 14: Investment Alternatives for the Individual Investor

Quote: Many highly specialized mutual funds have been established in order to exploit investors’ interests in the latest market fad. Many investors mistakenly choose their money managers the same way they pick horses at the race track. They see who has performed well lately and bet on them. –page 224 & 227

• Investors are inundated with information and investments that often cater to the worst human biases
• The desire for quick and easy profits by running with the herd is an overwhelming but costly impulse
• Always verify a money-manager invests their own money alongside their clients
• Investment managers should be assessed over a full market cycle involving up and down markets
• Only during the down cycle do the merits of capital preservation become apparent

Notes About Today’s Mania:

The media today is filled with stories of people achieving great wealth without working. Day trading is back just as it was in 1999. Inexperienced retail investors are being lured into markets with valuations well above the levels seen in 2000. Cleantech stocks today are analogous to 2000.

Lacking any type of ordered process, they often follow fads on various internet websites. The market price in periods like today often turn out to be “far too high” of a price. Where there is euphoria we urge caution.

Our research documents the unfortunate similarities between today and 2000. There are some charts that we believe will go down as infamous. Examples include:

• Chart of tech valuations
• Chart of the rise of recklessly priced firms
• The staggering market caps ascribed to money-losing firms
• The extraordinary valuation ascribed to firms that actually are charging investors to own shares

Today’s bubble is in full force and the financial and social costs are already soaring. Individuals have seen their life savings wiped out and others have committed suicide. The losses due to the collision of inexperience and treacherous stock promotion schemes is tragic. We hope this post brings prudence and safety to someone.

For investors interested in compounding capital using a disciplined process we may be able to help. Learn more about us here.

Why is the Margin of Safety book so expensive?

For young investors or those unfamiliar with this legendary text, KCR notes there are only ~5,000 original copies in existence. For many investors who grew up in the 1990s, the book represents a near-comprehensive education in how to compound wealth safely. Building on Warren Buffett’s many letters to shareholders and Graham and Dodds’ “Security Analysis”, fans of financial history like KCR believe the book a Margin of Safety is nothing short of a collector’s item whose value will only rise over the years. With the sale price well over $1,000 per book, we are not alone in this belief. As a result, this is the only book we do not offer a free copy of.

Basic subscribers are welcome to a free copy of any of the books we have written up excluding Margin of Safety.

New one year Enterprise subscribers can also qualify for a complimentary one year subscription to The Economist, The Financial Times, or Nikkei Asia.

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