15 More Ideas from Seth Klarman’s Margin of Safety
Continuing from where I left off, here are 15 more ideas from Klarman’s Margin of Safety. For the most part, I will directly quote Klarman given that the learnings are best served from the horse’s mouth.
I took the liberty of merging the two sets of notes into a PDF.
1. Efficient markets and its various forms
Klarman favours the notion that markets are sporadically efficient, but more often demonstrate weak efficiency.
“Investors should understand not only what value investing is but also why it is a successful investment philosophy. At the very core of its success is the recurrent mispricing of securities in the marketplace. Value investing is, in effect, predicated on the proposition that the efficient market hypothesis is frequently wrong. If, on the one hand, securities can become undervalued or overvalued, which I believe to be incontrovertibly true, value investors will thrive. If, on the other hand, all securities at some future date become fairly and efficiently priced, value investors will have nothing to do. It is important, then, to consider whether or not the financial markets are efficient”.
The efficient market hypothesis takes three forms.
The weak form maintains that past stock prices provide no useful information on the future direction of stock prices. In other words, technical analysis (analysis of past price fluctuations) cannot help investors.
The semistrong form says that no published information will help investors to select undervalued securities since the market has already discounted all publicly available information into securities prices.
The strong form maintains that there is no information, public or private, that would benefit investors.
The semistrong and strong forms imply that fundamental analysis and stock picking are useless. Klarman favours the weak form, and suggests larger entities tend to be priced more efficiently.
“As to the other forms: yes, the market does tend to incorporate new information into prices—securities prices are neither random nor do they totally ignore available information—yet the market is far from efficient. There is simply no question that investors applying disciplined analysis can identify inefficiently priced securities, buy and sell accordingly, and achieve superior returns. The pricing of large-capitalization stocks tends to be more efficient than that of small-capitalization stocks, distressed bonds, and other less-popular investment fare. While hundreds of investment analysts follow IBM, few, if any, cover thousands of small-capitalization stocks and obscure junk bonds. Investors are more likely, therefore, to find inefficiently priced securities outside the Standard and Poor's 100 than within it. Even among the most highly capitalized issues, however, investors are frequently blinded by groupthink, thereby creating pricing inefficiencies. Is it reasonable to expect that in the future some securities will continue to be significantly mispriced from time to time? I believe it is. The elegance of the efficient-market theory is at odds with the reality of how the financial markets operate”.
2. The 80/20 rule
The 80/20 rule relates to the research process and the idea that the first 80% of the available information is gathered in the first 20% of the time spent. Most of the time, that additional 20% is busy work.
“Some investors insist on trying to obtain perfect knowledge about their impending investments, researching companies until they think they know everything there is to know about them. They study the industry and the competition, contact former employees, industry consultants, and analysts, and become personally acquainted with top management. They analyze financial statements for the past decade and stock price trends for even longer. This diligence is admirable, but it has two shortcomings”.
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.
“This is not to say that fundamental analysis is not useful. It certainly is. But information generally follows the well-known 80/20 rule: the first 80 percent of the available information is gathered in the first 20 percent of the time spent. The value of in-depth fundamental analysis is subject to diminishing marginal returns. Information is not always easy to obtain. Moreover, business information is highly perishable. Economic conditions change, industries are transformed, and business results are volatile. The effort to acquire current, let alone complete information is never-ending. Meanwhile, other market participants are also gathering and updating information, thereby diminishing any investor's informational advantage”.
“David Dreman recounts "the story of an analyst so knowledgeable about Clorox that 'he could recite bleach shares by brand in every small town in the Southwest and tell you the production levels of Clorox's line number 2, plant number 3. But somehow, when the company began to develop massive problems, he missed the signs. Most investors strive fruitlessly for certainty and precision, avoiding situations in which information is difficult to obtain. Yet high uncertainty is frequently accompanied by low prices. By the time the uncertainty is resolved, prices are likely to have risen. Investors frequently benefit from making investment decisions with less than perfect knowledge and are well rewarded for bearing the risk of uncertainty. The time other investors spend delving into the last unanswered detail may cost them the chance to buy in at prices so low that they offer a margin of safety despite the incomplete information”.
3. The test of a down market
“When the overall market is strong, the rising tide lifts most ships. Profitable investments are easy to come by, mistakes are not costly, and high risks seem to pay off, making them seem reasonable in retrospect. As the saying goes, "You can't tell who's swimming naked till the tide goes out." A market downturn is the true test of an investment philosophy. Securities that have performed well in a strong market are usually those for which investors have had the highest expectations. When these expectations are not realized, the securities, which typically have no margin of safety, can plummet. Stocks that fit this description are sometimes referred to as "torpedo stocks," a term that describes the disastrous effect owning them can have on one's investment results”.
“In depressed financial markets, it is said, some securities are so out of favor that you cannot give them away. Some stocks sell below net working capital per share, and a few sell at less than net cash (cash on hand less all debt) per share; many stocks trade at an unusually low multiple of current earnings and cash flow and at a significant discount to book value. Whenever the financial markets fail to fully incorporate fundamental values into securities prices, an investor's margin of safety is high. Moreover, securities priced as if nothing could go right stand to benefit from a change in perception. If investors refocused on the strengths rather than on the difficulties, higher security prices would result. When fundamentals do improve, investors could benefit both from better results and from an increased multiple applied to them”.
4. The Importance of a Margin of Safety
Benjamin Graham would suggest that a $1 business might be worth $0.75 or $1.25 at some point in the near future. Thus, he would not be inclined to pay $1 for that business and would rather have a wider margin of safety at, say, $0.40 or lower. Buffett once described the margin of safety as a matter of tolerance; "When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And that same principle works in investing."
“Graham was only interested in buying at a substantial discount from underlying value. By investing at a discount, he knew that he was unlikely to experience losses. The discount provided a margin of safety. Because investing is as much an art as a science, investors need a margin of safety. A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable, and rapidly changing world. According to Graham, "The margin of safety is always dependent on the price paid. For any security, it will be large at one price, small at some higher price, nonexistent at some still higher price”.
What is the requisite margin of safety for an investor? The answer can vary from one investor to the next. How much bad luck are you willing and able to tolerate? How much volatility in business values can you absorb? What is your tolerance for error? It comes down to how much you can afford to lose. Most investors do not seek a margin of safety in their holdings. Institutional investors who buy stocks as pieces of paper to be traded and who remain fully invested at all times fail to achieve a margin of safety. Greedy individual investors who follow market trends and fads are in the same boat. The only margin investors who purchase Wall Street underwritings or financial-market innovations usually experience is a margin of peril”.
5. Bottom-up vs. Top-down
Klarman likens top-down investing to the greater-fool or greater-genius games; neither of which are favourable environments for mortals. Conversely, a bottom-up approach is simpler, has fewer variables, and relies on a smaller number of things having to go your way.
Top-down
“A great many professional investors employ a topdown 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. Practitioners need to accurately forecast macroeconomic conditions and then correctly interpret their impact on various sectors of the overall economy, on particular industries, and finally on specific companies. As if that were not complicated enough, it is also essential for top-down investors to perform this exercise quickly as well as accurately, or others may get there first and, through their buying or selling, cause prices to reflect the forecast macroeconomic developments, thereby eliminating the profit potential for latecomers. By way of example, a top-down investor must be correct on the big picture, correct in drawing conclusions from that, correct in applying those conclusions to attractive areas of investment, correct in the specific securities purchased, and, finally, be early in buying these securities. The top-down investor thus faces the daunting task of predicting the unpredictable more accurately and faster than thousands of other bright people, all of them trying to do the same thing”.
“It is not clear whether top-down investing is a greaterfool game, in which you win only when someone else overpays, or a greater-genius game, winnable at best only by those few who regularly possess superior insight. In either case, it is not an attractive game for risk-averse investors. There is no margin of safety in top-down investing. Topdown investors are not buying based on value; they are buying based on a concept, theme, or trend. There is no definable limit to the price they should pay, since value is not part of their purchase decision. It is not even clear whether top-down-oriented buyers are investors or speculators. If they buy shares in businesses that they truly believe will do well in the future, they are investing. If they buy what they believe others will soon be buying, they may actually be speculating”.
Bottom-up
“Paradoxically a bottom-up strategy is in many ways simpler to implement than a top-down one. While a top-down investor must make several accurate predictions in a row, a bottom-up investor is not in the forecasting business at all. The entire strategy can be concisely described as "buy a bargain and wait." Investors must learn to assess value in order to know a bargain when they see one. Then they must exhibit the patience and discipline to wait until a bargain emerges from their searches and buy it, regardless of the prevailing direction of the market or their own views about the economy at large. One significant and not necessarily obvious difference between a bottom-up and top-down strategy is the reason for maintaining cash balances at times. Bottom-up investors hold cash when they are unable to find attractive investment opportunities and put cash to work when such opportunities appear. A bottom-up investor chooses to be fully invested only when a diversified portfolio of attractive investments is available. Topdown investors, by contrast, may attempt to time the market, something bottom-up investors do not do. Market timing involves making a judgment about the overall market direction; when top-down investors believe the market will decline, they sell stocks to hold cash, awaiting a more bullish opinion”.
“Bottom-up investors can easily determine when the original reason for making an investment ceases to be valid. When the underlying value changes, when management reveals itself to be incompetent or corrupt, or when the price appreciates to more fully reflect underlying business value, a disciplined investor can reevaluate the situation and, if appropriate, sell the investment. Huge sums have been lost by investors who have held on to securities after the reason for owning them is no longer valid. In investing it is never wrong to change your mind. It is only wrong to change your mind and do nothing about it. Top-down investors, by contrast, may find it difficult to know when their bet is no longer valid. If you invest based on a judgment that interest rates will decline but they rise instead, how and when do you decide that you were wrong? Your bet may eventually prove correct, but then again it may not”.
6. Business Valuation: Net Present Value
Klarman shares the three forms of valuation that he finds most useful; net present value (NPV) analysis, liquidation value (LV), and stock market value (SMV).
“NPV is the discounted value of all future cash flows that a business is expected to generate. When future cash flows' are reasonably predictable and an appropriate discount rate can be chosen, NPV analysis is one of the most accurate and precise methods of valuation. Unfortunately future cash flows are usually uncertain, often highly so. Moreover, the choice of a discount rate can be somewhat arbitrary. These factors together typically make present value analysis an imprecise and difficult task.
“There are many investors who make decisions solely on the basis of their own forecasts of future growth. After all, the faster the earnings or cash flow of a business is growing, the greater that business's present value. Yet several difficulties confront growth-oriented investors. First, such investors frequently demonstrate higher confidence in their ability to predict the future than is warranted. Second, for fast-growing businesses even small differences in one's estimate of annual growth rates can have a tremendous impact on valuation.' Moreover, with so many investors attempting to buy stock in growth companies, the prices of the consensus choices may reach levels unsupported by fundamentals. Since entry to the "Business Hall of Fame" is frequently through a revolving door, investors may at times be lured into making overly optimistic projections based on temporarily robust results, thereby causing them to overpay for mediocre businesses”.
7. Business Valuation: Liquidation Value
“The expected proceeds if a company were to be dismantled and the assets sold off. The liquidation value of a business is a conservative assessment of its worth in which only tangible assets are considered and intangibles, such as going-concern value, are not. Accordingly, when a stock is selling at a discount to liquidation value per share, a near rock-bottom appraisal, it is frequently an attractive investment. A liquidation analysis is a theoretical exercise in valuation but not usually an actual approach to value realization. The assets of a company are typically worth more as part of a going concern than in liquidation, so liquidation value is generally a worst-case assessment”.
“A liquidation is, in a sense, one of the few interfaces where the essence of the stock market is revealed. Are stocks pieces of paper to be endlessly traded back and forth, or are they proportional interests in underlying businesses? A liquidation settles this debate, distributing to owners of pieces of paper the actual cash proceeds resulting from the sale of corporate assets to the highest bidder. A liquidation thereby acts as a tether to reality for the stock market, forcing either undervalued or overvalued share prices to move into line with actual underlying value”.
8. Business Valuation: Stock Market Value
“Stock market value is an estimate of the price at which a company, or its subsidiaries considered separately, would trade in the stock market. Less reliable than the other two, this method is only occasionally useful as a yardstick of value. Occasionally investors must rely on the public equity and debt markets to provide an approximation of the worth of a security. While the stock market's vote, especially over the long run, is not necessarily accurate, it does provide an approximate near-term appraisal of value”.
“If the prices at which stocks trade in the market is a reasonable approximation of their value, then isn't this an admission that the stock market is efficient, the antithesis of one of the basic tenets of value investing? My answer is decidedly no. The stock market valuation of comparable businesses is but one of several valuation tools and provides a yardstick of what a security, if not a business, might bring if sold tomorrow”.
“Stock market value has its shortcomings as a valuation tool. You would not use stock market value to appraise each of the companies in an industry. It would be circular reasoning to observe that since newspaper companies tend to trade in the market at, say, eight times pretax cash flow, that is what they must be worth. Knowing the stock market's appraisal for the newspaper industry would be of some use, however, in estimating the near-term trading price of the newspaper subsidiary about to be spun off to the shareholders of a media conglomerate”.
9. Prediction
“If investors could predict the future direction of the market, they would certainly not choose to be value investors all the time. Indeed, when securities prices are steadily increasing, a value approach is usually a handicap; out-of-favor securities tend to rise less than the public's favorites. When the market becomes fully valued on its way to being overvalued, value investors again fare poorly because they sell too soon. The most beneficial time to be a value investor is when the market is falling. This is when downside risk matters and when investors who worried only about what could go right suffer the consequences of undue optimism.
Value investors invest with a margin of safety that protects them from large losses in declining markets. Those who can predict the future should participate fully, indeed on margin using borrowed money, when the market is about to rise and get out of the market before it declines. Unfortunately, many more investors claim the ability to foresee the market's direction than actually possess that ability. (I myself have not met a single one.) Those of us who know that we cannot accurately forecast security prices are well advised to consider value investing, a safe and successful strategy in all investment environments”.
10. Paying up for growth
Investors are typically overly optimistic in their assessment of the future. This fact alone is enough to warrant scepticism for paying up for growth.
“There are many investors who make decisions solely on the basis of their own forecasts of future growth. After all, the faster the earnings or cash flow of a business is growing, the greater that business's present value. Yet several difficulties confront growth-oriented investors”.
“Investors tend to oversimplify growth into a single number, growth is, in fact, comprised of numerous moving parts which vary in their predictability. For any particular business, for example, earnings growth can stem from increased unit sales related to predictable increases in the general population, to increased usage of a product by consumers, to increased market share, to greater penetration of a product into the population, or to price increases. Specifically, a brewer might expect to sell more beer as the drinking-age population grows but would aspire to selling more beer per capita as well. Budweiser would hope to increase market share relative to Miller. The brewing industry might wish to convert whiskey drinkers into beer drinkers or reach the abstemious segment of the population with a brand of nonalcoholic beer. Over time companies would seek to increase price to the extent that it would be expected to result in increased profits”.
“Investors are often overly optimistic in their assessment of the future. A good example of this is the common response to corporate write-offs. This accounting practice enables a cornpany at its sole discretion to clean house, instantaneously ridding itself of underperforming assets, uncollectible receivables, bad loans, and the costs incurred in any corporate restructuring accompanying the write-off. Typically such moves are enthusiastically greeted by Wall Street analysts and investors alike; post-write-off the company generally reports a higher return on equity and better profit margins. Such improved results are then projected into the future, justifying a higher stock market valuation. Investors, however, should not so generously allow the slate to be wiped clean. When historical mistakes are erased, it is too easy to view the past as error free. It is then only a small additional step to project this error-free past forward into the future, making the improbable forecast that no currently profitable operation will go sour and that no poor investments will ever again be made”.
11. The signal of insider buying
Insiders sell for a variety of reasons, but they often buy for one; they think the value of the shares are set to increase in the short to medium term.
“In most instances, no one understands a business and its prospects better than the management. Therefore investors should be encouraged when corporate insiders invest their own money alongside that of shareholders by purchasing stock in the open market. The motivation of corporate management can be a very important force in determining the outcome of an investment. Some companies provide incentives for their managements with stock-option plans and related vehicles. Usually these plans give management the specific incentive to do what they can to boost the company's share price.
While management does not control a company's stock price, it can greatly influence the gap between share price and underlying value and over time can have a significant influence on value itself. If the management of a company were compensated based on revenues, total assets, or even net income, it might ignore share price while focusing on those indicators of corporate performance. If, however, management were provided incentives to maximize share price, it would focus its attention differently. For example, the management of a company whose stock sold at $25 with an underlying value of $50 could almost certainly boost the market price by announcing a spinoff, recapitalization, or asset sale, with the result of narrowing the gap between share price and underlying value. The repurchase of shares on the open market at $25 would likely give a boost to the share price as well as causing the underlying value of remaining shares to increase above $50. Obviously investors need to be alert to the motivations of managements at the companies in which they invest”.
12. Reducing Portfolio Risk
Investment must be thought of as more than stock selection or making a series of solid individual investment decisions. This collection of stocks requires capable portfolio management, taking into account diversification, hedging, and the management of portfolio cash flow. Portfolio management is a further means of risk reduction for investors.
Appropriate Diversification
“Even relatively safe investments entail some probability, however small, of downside risk. The deleterious effects of such improbable events can best be mitigated through prudent diversification. The number of securities that should be owned to reduce portfolio risk to an acceptable level is not great; as few as ten to fifteen different holdings usually suffice. Diversification for its own sake is not sensible. This is the index fund mentality: if you can't beat the market, be the market. Advocates of extreme diversification—which I think of as overdiversification—live in fear of company-specific risks; their view is that if no single position is large, losses from unanticipated events cannot be great. My view is that an investor is better off knowing a lot about a few investments than knowing only a little about each of a great many holdings. One's very best ideas are likely to generate higher returns for a given level of risk than one's hundredth or thousandth best idea. Diversification is potentially a Trojan horse. 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”.
Hedging
“Market risk—the risk that the overall stock market could decline—cannot be reduced through diversification but can be limited by hedging. An investor's choice among many possible hedging strategies depends on the nature of his or her underlying holdings. A diversified portfolio of large capitalization stocks, for example, could be effectively hedged through the sale of an appropriate quantity of Standard & Poor's 500 index futures. This strategy would effectively eliminate both profits and losses due to broad-based stock market fluctuations. If a portfolio were hedged through the sale of index futures, investment success would thereafter depend on the performance of one's holdings compared with the market as a whole. A portfolio of interest-rate-sensitive stocks could be hedged by selling interest rate futures or purchasing or selling appropriate interest rate options. A gold-mining stock portfolio could be hedged against fluctuations in the price of gold by selling gold futures. A portfolio of import- or export-sensitive stocks could be partially hedged through appropriate transactions in the foreign exchange markets. It is not always smart to hedge. When the available return is sufficient, for example, investors should be willing to incur risk and remain unhedged”. Hedges can be expensive to buy and time-consuming to maintain, and overpaying for a hedge is as poor an idea as overpaying for an investment. When the cost is reasonable, however, a hedging strategy may allow investors to take advantage of an opportunity that otherwise would be excessively risky. In the best of all worlds, an investment that has valuable hedging properties may also be an attractive investment on its own merits”.
13. Reflexivity between market price and underlying value
“A complicating factor in securities analysis is the reflexive or reciprocal relationship between security prices and the values of the underlying businesses. In The Alchemy of Finance George Soros stated, "Fundamental analysis seeks to establish how underlying values are reflected in stock prices, whereas the theory of reflexivity shows how stock prices can influence underlying values." In other words, Soros's theory of reflexivity makes the point that its stock price can at times significantly influence the value of a business”.
“Investors must not lose sight of this possibility. Most businesses can exist indefinitely without concern for the prices of their securities as long as they have adequate capital. When additional capital is needed, however, the level of security prices can mean the difference between prosperity, mere viability, and bankruptcy. If, for example, an undercapitalized bank has a high stock price, it can issue more shares and become adequately capitalized, a form of self-fulfilling prophecy. The stock market says there is no problem, so there is no problem. In early 1991, for example, Citicorp stock traded in the teens and the company was able to find buyers for newly issued securities. If its stock price had been in the low single digits, however, it would have been unable to raise additional equity capital, which could have resulted in its eventual failure. This is another, albeit negative form of self-fulfilling prophecy, whereby the financial markets' perception of the viability of a business influences the outcome”.
“Another form of reflexivity exists when the managers of a business accept its securities' prices, rather than business fundamentals, as the determining factor in valuation. If the management of a company with an undervalued stock believes that the depressed market price is an accurate reflection of value, they may take actions that prove the market right. Stock could be issued in a secondary offering or merger, for example, at a price so low that it significantly dilutes the value of existing shares. As another example of reflexivity, the success of a reorganization plan for a bankrupt company may depend on certain values being realized by creditors. If the financial markets are depressed at the time of reorganization, it could be difficult, perhaps impossible, to generate agreed values for creditors if those values depend on the estimated market prices of debt and equity securities in the reorganized company. In circular fashion, this could serve to depress even further the prices of securities in this bankrupt company. Reflexivity is a minor factor in the valuation of most securities most of the time, but occasionally it becomes important. This phenomenon is a wild card, a valuation factor not determined by business fundamentals but rather by the financial markets themselves”.
14. Waiting for the right pitch
Invest in businesses you understand. Expanding the circle of comfort is fine, but straying too far can result in excessive and unnecessary risk borne from not knowing what you don’t know.
“Most institutional investors, unlike value investors, feel compelled to be fully invested at all times. They act as if an umpire were calling balls and strikes—mostly strikes—thereby forcing them to swing at almost every pitch and forego batting selectivity for frequency. Many individual investors, like amateur ballplayers, simply can't distinguish a good pitch from a wild one. Both undiscriminating individuals and constrained institutional investors can take solace from knowing that most market participants feel compelled to swing just as frequently as they do. For a value investor a pitch must not only be in the strike zone, it must be in his "sweet spot." Results will be best when the investor is not pressured to invest prematurely.
There may be times when the investor does not lift the bat from his shoulder; the cheapest security in an overvalued market may still be overvalued. You wouldn't want to settle for an investment offering a safe 10 percent return if you thought it very likely that another offering an equally safe 15 percent return would soon materialize. An investment must be purchased at a discount from underlying worth. This makes it a good absolute value. Being a good absolute value alone, however, is not sufficient for investors must choose only the best absolute values among those that are currently available. A stock trading at one-half of its underlying value may be attractive, but another trading at one-fourth of its worth is the better bargain”.
15. Being contrarian
Klarman believes value investors are contrarian by design. Popular stocks are rarely out of favour and are more likely to be influenced by herd bias.
“Securities in favour have already been bid up in price on the basis of optimistic expectations and are unlikely to represent good value that has been overlooked. If value is not likely to exist in what the herd is buying, where may it exist? In what they are selling, unaware of, or ignoring. When the herd is selling a security, the market price may fall well beyond reason. Ignored, obscure, or newly created securities may similarly be or become undervalued.
Investors may find it difficult to act as contrarians for they can never be certain whether or when they will be proven correct. Since they are acting against the crowd, contrarians are almost always initially wrong and likely for a time to suffer paper losses. By contrast, members of the herd are nearly always right for a period. Not only are contrarians initially wrong, they may be wrong more often and for longer periods than others because market trends can continue long past any limits warranted by underlying value. Holding a contrary opinion is not always useful to investors, however. When widely held opinions have no influence on the issue at hand, nothing is gained by swimming against the tide. It is always the consensus that the sun will rise tomorrow, but this view does not influence the outcome. By contrast, when majority opinion does affect the outcome or the odds, contrary opinion can be put to use. When the herd rushes into home health-care stocks, bidding up prices and thereby lowering available returns, the majority has altered the risk/reward ratio, allowing contrarians to bet against the crowd with the odds skewed in their favor”.
Thanks for reading,
Conor
thank you!