15 Ideas from Seth Klarman’s Margin of Safety
15 Ideas from Seth Klarman’s Margin of Safety
(Part 1): Risk-Averse Value Investing Strategies for the Thoughtful Investor
Out of Print ≠ Out of Style
Seth Klarman’s infamous book, Margin of Safety, was published in 1991 in limited supply. It’s rumored that only 5,000 copies of the first edition were printed. At the time, Klarman was a relative unknown and the book didn’t sell very well. Years later Klarman became a household name (well, certain households) and demand for the book was stronger than ever. The book ceased publishing years ago, however. Klarman’s refusal to republish means there has long been an imbalance in supply and demand; some copies have fetched thousands of dollars second-hand at online auction sites1.
In Baupost’s 2012 year-end letter, Klarman wrote that he “endeavoured to make the book timeless - more about how to think about investing than about what one should buy or sell at any given moment”. The book was originally published to spell out “why financial markets weren’t, and never would be, efficiently priced”. He remarks on how markets have changed since publishing the book some 20 years earlier; concluding by suggesting the fundamental lessons remain intact.
“Some of the categories of opportunity I wrote about hardly exist today (e.g., thrift conversations), while others that have emerged in recent years couldn’t have been specifically contemplated two decades earlier (e.g., distressed structured products). But while the categories and the specific opportunities may have changed, the fundamental lessons remain. Modern finance has lately meant financial engineering, high-speed trading, esoteric derivatives, off-balance-sheet financing, and quantitative easing. As Jim Grant has observed, in science progress is cumulative; in finance it is cyclical”.
One of the key departures Klarman highlights from the 1990s into 2010s is the extent of quantitative easing; “money cannot be printed by whim or fiat as it is relentlessly created today”.
“In Margin of Safety, there was no chapter on investing in markets in which nearly everything is manipulated or managed by governments in the name of delivering prosperity - or at least avoiding its antithesis. Interest rates were not driven to zero in the hopes of driving stock prices higher. Governments did not issue massive amounts of debt with one arm, then repurchase it with another and claim a large profit from such activity. Unemployment and inflation data were not massaged with such abstruse adjustments and other distorting techniques such that you actually had a chance of figuring out where things stood”.
In hindsight, these themes discussed in 2012 were prescient warnings for what was to come. We can assume that while the core lessons of the book are evergreen, the opportunity set and assumptions about market infrastructure discussed in the 1990s are no longer relevant. The opportunities discussed in the book no longer reflect Klarman’s approach, which is likely why we have seen a halt to publishing. This is a common phenomenon in investment classics. Glide through the pages of Benjamin Graham’s The Intelligent Investor or Security Analysis and you’ll find the book’s examples incredibly dated.
*Camera pans to a 20-something scratching their head over why they’d want to analyse a railway bond or why stock prices are quoted in fractions.
But these books still possess incredible value through the practical, evergreen, commentary on the importance of behavioural edge. Today, investors can access Klarman’s perspective through his annual Baupost year-end letters if they are lucky enough to find a source; as they are distributed confidentially.
15 Ideas from Seth Klarman’s Margin of Safety
I secured a copy of his original work, Margin of Safety, and wanted to share a few timeless takeaways. For the most part, I will directly quote Klarman given that the learnings are best served from the horse’s mouth.
1. Trading Sardines, the essence of speculation
The phrase “trading sardines” is one I am sure some of you have heard before. The original story involves a speculative frenzy over canned sardines with buyers exhibiting no intention of consumption.
“There is the old story about the market craze in sardine trading when the sardines disappeared from their traditional waters in Monterey, California. The commodity traders bid them up and the price of a can of sardines soared. One day a buyer decided to treat himself to an expensive meal and actually opened a can and started eating. He immediately became ill and told the seller the sardines were no good. The seller said, "You don't understand. These are not eating sardines, they are trading sardines”.
Klarman argues that investors have become increasingly speculative. In turn, they have become lazy. Relying on the great fool theory, the hope that another investor will buy your speculative issue from you at a higher price, encourages investors to think of stocks as sardines for trading, not eating.
“Like sardine traders, many financial market participants are attracted to speculation, never bothering to taste the sardines they are trading. Speculation offers the prospect of instant gratification; why get rich slowly if you can get rich quickly? Moreover, speculation involves going along with the crowd, not against it. There is comfort in consensus; those in the majority gain confidence from their very number. Today many financial market participants, knowingly or unknowingly, have become speculators. They may not even realize that they are playing a "greater-fool game," buying over-valued securities and expecting—hoping—to find someone, a greater fool, to buy from them at a still higher price”.
2. Not all selloffs are buying opportunities
“Just as many generals persist in fighting the last war, most investment formulas project the recent past into the future”, says Klarman. The fascination with hunting for low PE stocks, one example of this behaviour, is like driving a car looking only in the rear-view mirror, he remarks.
“Stocks with a low P/E ratio are often depressed because the market price has already discounted the prospect of a sharp fall in earnings. Investors who buy such stocks may soon find that the P/E ratio has risen because earnings have declined. Many investors, like Pavlov's dog, will foolishly look to the next market selloff, regardless of its proximate cause, as another buying "opportunity." The financial markets are far too complex to be incorporated into a formula. Moreover, if any successful investment formula could be devised, it would be exploited by those who possessed it until competition eliminated the excess profits. Investors would be much better off to redirect the time and effort committed to devising formulas into fundamental analysis of specific investment opportunities”.
3. Mr Market is a tool to be wielded
Mr Market is an avenue for investment guidance and feedback loops for some and a vehicle of opportunity for others.
“Mr. Market's daily fluctuations may seem to provide feedback for investors' recent decisions. For a recent purchase decision rising prices provide positive reinforcement; falling prices, negative reinforcement. If you buy a stock that subsequently rises in price, it is easy to allow the positive feedback provided by Mr. Market to influence your judgment. You may start to believe that the security is worth more than you previously thought and refrain from selling, effectively placing the judgment of Mr. Market above your own. You may even decide to buy more shares of this stock, anticipating Mr. Market's future movements. As long as the price appears to be rising, you may choose to hold, perhaps even ignoring deteriorating business fundamentals or a diminution in underlying value.
When the price of a stock declines after its initial purchase, most investors, somewhat naturally, become concerned. They start to worry that Mr. Market may know more than they do or that their original assessment was in error. It is easy to panic and sell at just the wrong time. Yet if the security were truly a bargain when it was purchased, the rational course of action would be to take advantage of this even better bargain and buy more”.
4. Business reality vs. Stock price
Avoid confusing the real success of a business with its mirrored success in the stock market. Just because a stock price rises, it does not mean the underlying business is doing well or that the price movement is justified. The same goes for falling stock prices and the indication that this company is struggling or the corresponding decrease in market-quoted value is just.
“It is vitally important for investors to distinguish stock price fluctuations from underlying business reality. If the general tendency is for buying to beget more buying and selling to precipitate more selling, investors must fight the tendency to capitulate to market forces. You cannot ignore the market—ignoring a source of investment opportunities would obviously be a mistake—but you must think for yourself and not allow the market to direct you. Value in relation to price, not price alone, must determine your investment decisions. If you look to Mr. Market as a creator of investment opportunities (where price departs from underlying value), you have the makings of a value investor. If you insist on looking to Mr. Market for investment guidance, however, you are probably best advised to hire someone else to manage your money”.
5. Stock prices move for 2 reasons
Those two reasons are; to reflect a business reality (more accurately, investor perception of that reality) or to reflect short-term variation in supply and demand.
Changes in business reality: “Reality can change in a number of ways, some company-specific, others macroeconomic in nature. If Coca-Cola's business expands or prospects improve and the stock price increases proportionally, the rise may simply reflect an increase in business value. If Aetna's share price plunges when a hurricane causes billions of dollars in catastrophic losses, a decline in total market value approximately equal to the estimated losses may be appropriate.
When the shares of Fund American Companies, Inc., surge as a result of the unexpected announcement of the sale of its major subsidiary, Fireman's Fund Insurance Company, at a very high price, the price increase reflects the sudden and nearly complete realization of underlying value. On a macroeconomic level a broad-based decline in interest rates, a drop in corporate tax rates, or a rise in the expected rate of economic growth could each precipitate a general increase in security prices. Security prices sometimes fluctuate, not based on any apparent changes in reality, but on changes in investor perception”.
Changes in supply and demand: “In the short run supply and demand alone determine market prices. If there are many large sellers and few buyers, prices fall, sometimes beyond reason. Supply-and-demand imbalances can result from year-end tax selling, an institutional stampede out of a stock that just reported disappointing earnings, or an unpleasant rumour. Most day-to-day market price fluctuations result from supply-and-demand variations rather than from fundamental developments”.
Investors will most often not know why stock prices fluctuate. Yet, they will more than likely ascribe some explanation that may or may not be accurate. Investors like to feel like they understand what is going on and are uncomfortable with the unknown.
“They may change because of, in the absence of, or in complete indifference to changes in underlying value. In the short run investor perception may be as important as reality itself in determining security prices. It is never clear which future events are anticipated by investors and thus already reflected in today's security prices. Because security prices can change for any number of reasons and because it is impossible to know what expectations are reflected in any given price level, investors must look beyond security prices to underlying business value, always comparing the two as part of the investment process”.