How to Apply Lessons From Margin of Safety by Seth Klarman
A conservative investment strategy that beats the market
In 1992, hedge fund manager Seth Klarman published his seminal value investing book "Margin of Safety." This book is a must read for anyone investing in businesses for long-term investment opportunities.
It is such a classic that today, purchases a copy of this book will run you thousands of dollars... If you can even find one. But today, you can learn the main lessons from this book for free.
To overly simplify the main message of his book investors should figure out the fair value of an investment and only purchase when prices fall well below that fair value.
This is the margin of safety... Because even if you were a bit off in your calculations or the company underperforms, you can still make money on the investment. Or at least not lose as much.
This sounds simple.... But in practice this can be a very difficult thing to do. It requires an immense study of the markets, industry, and individual companies.
And at times like now (late 2022) when the market is crashing, it looks like there are no safe investments. But perhaps this is the perfect time to buy beaten down companies below their intrinsic value... And earn a superior rate of return in the markets.
Seth Klarman's Investing Hero
In the introduction Klarman gets right down to business. He says that investors like Warren Buffett and Charlie Munger know what they're doing.
We should study these successful investors and their investment decisions. We will see that these gentlemen buy businesses at fair values that will give them great investment returns. Their investment process allows them to build an investment portfolio of attractive investments at reasonable prices.
This way you can minimize the impact of bad luck on your investment portfolio. Reducing investment risk is one of the most important things people can do to be successful. It goes back to Buffett's two rules of investing: 1. Don't lose money. 2. Never forget rule #1.
Klarman also says we should study how others lost money. That way we can avoid their mistakes.
One of the biggest mistakes people make is investing in a mania. This is when we see investors, including our neighbors, flock to the hot stock. Often times the novice investor will feel a bit of FOMO (fear of missing out). And they will jump into the stock as it spikes higher.... And they inevitably lose money and reality sets into the stock market.
This kind of investing is easy because you're following the crowd. But speculation like this is a waste of time. It's dangerous. We want to take the harder road and remain disciplined And invest where the crowds are not.
The Efficiency Of The Market
Efficient markets is a scam. If markets were efficient, value investing wouldn't be a thing.
Value investing is based on the idea that the market is inefficient and investors can beat it by buying companies whose shares are selling at low prices relative to their intrinsic worth. Value investors look for stocks trading at a discount to their underlying economic fundamentals. These stocks tend to be cheap because the market doesn't recognize how good they really are.
But eventually, hopefully after we've invested, the market realizes how undervalued these companies are. And the price rises.
We can take advantage of extreme volatility in the markets buy buying low. Then if we take a long-term investment horizon, we can earn superior returns.
How Wall Street Works Against Investors
Wall Street is supposed to work for investors. But there are incentives for Wall Street to sell products that don't always serve the best interest of investors. In fact, there are even incentives for investment bankers and hedge fund managers to make money while undermining the companies they're supposedly helping.
We can look at IPOs as an example of this. Klarman says, "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 of every underwriting."
He goes on to say the deck is stacked against buyers of IPOs. Steer clear of the initial offering. This isn't to say there isn't a time to make an investment in a company that has recently gone public though. Commonly there's a time about six months after the IPO when insider's lock-up period ends. And they can sell stocks. Look for irrational changes in the market price around that period.
Institutional Investors also tend to do a poor job managing money. Their primary goal is to not to deviate too far from the overall stock market return. If they go through a periods of underperformance they could face investor redemptions and lose their job.
Therefore, it is prudent for individuals to take control of their investments.
Value Investing: The Art of Business Valuation
The key lessons in this book revolve around value investing.
First, let's talk about what value investing is not. It's about buying the cheapest security on the market. It's not about only buying on market declines nor is it about an endless process to find the perfect investment.
Klarman is not a fan of top-down investors. He says, "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."
He says this method gives no margin for error. It requires being right about the future. That's a difficult proposition. Whereas looking for companies trading below their intrinsic values is easier.
Paying too high a price for individual investments can eliminate returns of even perfect trade execution over many years.
One lesson investors today could have heeded more closely is that Klarman said during periods of unusually low interest rates, all securities tend to become overpriced. Value investors need to be careful during periods of low interest. As of the time of writing, fall 2022, we are seeing the effects of investing in low interest rate environments... Eventually those low interest rates end. And market participants are getting wrecked as the overvalued market corrects.
But now we can likely find some attractive opportunities in the markets if we look closely. To do that, investors need a very disciplined approach to the financial markets.
Another useful quote from the book is, "The first, and perhaps most important, step in the investment process is knowing where to look for opportunities..."
Areas of Opportunities for Investment Success
To find good investment ideas, it's important to find companies with catalysts. Some catalysts Klarman mentions are:
Thrift Conversions - when banks go public it's a good time to invest. it's an accounting trick, but essentially the book value doubles... And returns follow. Peter Lynch also talks about these.
Liquidations - if you take a quick look at the financial statements and see a stock is trading below book value, a liquidation can provide a quick return for investors.
Bankrupt securities - Sometimes companies can come out of bankruptcy in a dominant market position. And with its previous debts restructured are written off, the company is in a better financial position.
Spin-offs - Sometimes a company will spin-off a segment that is growing or unwanted. These can provide opportunities because often these spinoffs are not in any indexes right away. So any market tracking fund, is forced to sell the spun-off security. This pushes the price down and can build in a margin of safety for investors.
Rights Offerings - These offerings are often free for investors. And sometimes you can maintain the right and sell the original security for what you previously paid for it... Giving you a risk free investment. These can lead to great rates of return with no downside risk.
Margin of Safety Can Help Meet or Investment Goals
The lessons in this book can take our investing strategies from a speculative undertaking to a nearly surefire, market beating investment strategy. And help us find those asymmetric investment opportunities that allow us to beat the market. And finding sexy safety margins will help preserve our capital in the event of any unforeseen market fluctuations.
This investment book is a must read for any buy-and-hold investor... And even has some lessons we can apply to short-term trading.
No summary will do the book justice... But this should help give some ideas where to look for and how to apply Seth Klarman's Margin of Safety.