VALUE ESSENTIALS: MARGIN OF SAFETY (SETH KLARMAN)
This post is essentially going to cover the most important points of the well-known “Margin of Safety” by Seth Klarman. It might be just as useful for people new to the topic as to those who have read it several times and would like a short summary.
The first chapters basically explain how institutional investors can cause market inefficiency or, in other words, says why value investing works. To keep the length of this post appropriate and not to go into every detail (we do still recommend reading the book!), we would like to jump to the overview of value investing that Klarman gives. Three elements are crucial:
The bottom-up strategy separates the value investor from others; the investment focus should lie on specific investment opportunities. Know a few companies really well instead of knowing little about very many. In the best case, you can focus on just one company at a time, by trying to buy a bargain and to wait.
Focus on absolute instead of relative performance. You cannot beat the market every year. In fact, most of the time you are going to be wrong. But every investment that has been valuated correctly has the potential to help you beat the market in the long-term, which are you are very likely to do. It is necessary to tolerate long periods of underperformance. Cash reserves are crucial when no bargain is available. If the portfolio is fully invested and an opportunity comes along, get rid of companies closest to being fully valued.
Use a risk-averse approach. The Capital Asset Pricing Model suggests that for high returns, you have to take higher risks. But that is not the whole truth: The risk you take is significantly dependent on the structure of a company and the stock price. Example: Given a Beta (number for stock volatility) of 1, the same company at a stock price of 100 should be riskier than at the price of 50. That’s because value investors believe in an intrinsic value. Volatility is mistakenly called risk while making overpriced, ill-conceived or poorly managed investments creates much greater risk.
In rising markets, people tend to feel wealthy due to unrealized capital gains. Try to keep in mind that markets are not efficient most of the time and use that fact. Finally, you have to be aware that it is almost impossible to accurately evaluate a complex business, a range of value should be sufficient. Future Cash Flow calculations often create false certainty.
One remarkable note Klarman makes is on growth evaluation. Often, investors end up paying too much for growth, because it really is a guessing game. The entry to the business hall of fame is a revolving door, some people are right more often than others. Still, growth is motion of many parts with different predictability, not a single number. While it is quite easy to see causes of growth, it is hard to predict their effects. The key to success is keeping forecasts conservative.
Conservatism also helps when making investment timing decisions. At low interest rates, you should be more reluctant to commit capital to long-term holdings. Always have cash at hand for great opportunities that can come up when stock prices fall.
Valuation itself can be done in different ways, as Klarman explains. Three ways he mentions are:
Private market value is the valuation of businesses by prices paid recently for similar companies. The difficulty is that the middlemen whose numbers we have to trust do not necessarily have more insights than we could get ourselves.
Liquidation value often shows good opportunities as soon as companies trade for less than liquidation value. On a so called ‘fire sale’, companies have to sell inventory below carrying value. Also receivables are discounted. Following Graham, the ‘net-net working capital’, the working capital without long term liabilities, can be eroded by ongoing losses.
Finally, stock market value provides an approximate near-term appraisal of the company value. It might show accurately what a company is worth at the moment, without catalyst effects, but can diverge from future projections.
Always keep in mind that valuation is complex, imprecise, gives uncertain results and comes with many burdens. Earnings per share can be manipulated easily and e.g. the GAAP may require measures that do not reflect reality. The amortization of goodwill depresses earnings and nonrecurring gains boost them, making book value not always terribly useful. Always confine yourself to what you know to get an advantage over everyone else. There is never complete information for investors. Also, people usually get to know 80 % of the information in 20% of the time spent researching.
The following chapters cover specific investment situations like spinoffs, liquidation, recapitalizations, assets of financial institutions and distressed companies. They go quite deep into detail and provide nice examples. The last chapter on portfolio management comes with clear statements: No portfolio should be entirely liquid or illiquid. Diversification and hedging are important, but each stock needs to be a great one. Keep 10 to 15 holdings and know a lot about all of them. Hedge market risks that can influence your performance. Stay in touch with the market, unreasonable pricing can always occur. Leave some room for stocks to average down before buying. Finally, do not set a selling price when you buy, but adjust intrinsic value over time; it is still a long-term activity and value changes too. Also investing is a full-time job, if you pay enough attention.
We hope to have given you a useful summary of what we thought was especially helpful. In this case, we leave these insights uncommented but wholeheartedly give you the advice of reading ‘Margin of Safety’ yourself, if you have not done so.
Let us know, if you would like more ‘Value Essentials’ posts and feel free to ask any questions!