Margin Of Safety: Chapter 14

In this the final chapter, Klarman discusses the various avenues individual investors may exercise in managing their investments. Klarman argues that investing properly is a full-time job, and that it would be very difficult for individual investors to manage their own money if they have other employment. This leaves them two options:

1) Mutual Funds

2) Money Managers

Open-end mutual funds offer the investor access to both liquidity and the ability to sell for net asset value. On the other hand, many funds are driven by relative performance and often grow to sizes where market-beating returns are not possible. Since managers are compensated by assets under management, they are also prone to follow short-term trends in order to avoid falling behind their peers in the near-term which could trigger a mass exodus of investors.

Closed-end funds do not offer investors ready liquidity at net asset value, however, they may be prudent investments when they trade at substantial discounts to their net asset values. Under the mutual fund banner, Klarman recommends the Mutual Series Funds and the Sequoia Fund.

In evaluating money managers, Klarman suggests individual investors raise the following questions which will help select a manager:

• Do they manage their own money in parallel with their clients'?
  
• Has the size of the portfolio grown exceedingly large?
  
• What is the investment philosophy of the manager? Does it make long-term sense?
  

In evaluating investment results, investors must look deeper than a manager's historical investment returns. For example, any manager can generate phenomenal returns within a certain period of time. Are the returns described over at least one full business cycle? Also, were the returns generated using leverage, or were they generated despite the portfolio holding large amounts of cash (in which case risk is much lower)?

Klarman concludes the book by recommending that investors adopt a value-oriented investment approach. If they do not have the time to manage their money full-time, he recommends finding a trustworthy manager who employs this philosophy.

Margin Of Safety: Chapter 13

This chapter is about trading and portfolio management from a value investing point of view.

Portfolio management is described as an on-going process that is never complete. While certain businesses may be fairly stable, its prices will fluctuate over time, and so the investor must constantly monitor the situation. Value investors are not into buying certain industries or business ideas without regard to price, and so price changes are a fundamental factor that drive portfolio decisions.

Klarman also points out the need for portfolios to be somewhat liquid. Investors are advised not to purchase their entire positions at one go, but rather to leave room to buy in at cheaper prices should the stock go down. A good test for an investor is to consider whether he would indeed buy more of the stock were it to drop; if he is not, he is probably speculating and should not be buying in the first place!

The decision of when to sell a stock is also discussed. Determining when to buy a stock is usually a much easier decision for a value investor, since the stock at that time is trading below what the investor considers an adequate margin of safety. But when the stock is trading within the range of values the investor believes it to be worth, what is the investor to do? Klarman argues against selling after percentage gain thresholds or price targets have been reached. Instead, the investor should compare the investment to available alternative investments: it would be foolish to sell if there were no better investments and the stock was still undervalued, but it would be foolish not to sell if there are better bargains around!

 

Margin Of Safety: Chapter 12

This chapter describes some of the risks and opportunities associated with investing in distressed securities. While regular value investing involves dealing with a wide number of unknowns, distressed securities represent particularly complex situations. Because most investors are unwilling to put in the time and effort involved with analyzing such securities, Klarman believes the opportunities are plentiful in this realm.

There are three reasons a company might run into financial distress: operating issues, legal issues, and/or financial issues. Issuers can respond to such situations in one of three ways: continue to pay obligations, attempt to convert obligations into less stringent obligations (e.g. get debt holders to accept preferred stock), or default and declare bankruptcy. Investors must understand the implications to their investments as the above scenarios play out. Investors must also understand how other stakeholders will react to such situations, and understand the power that various stakeholders have (for example, one third of a stakeholder groups constitutes a blocking group, and can use this to further that stakeholder group's interests).

Klarman argues that while bankruptcies are often complex and difficult to analyze, investors who know what they are doing usually have tremendous opportunities for returns with very little risk. At the same time, someone who doesn't know what he's doing risks losing his entire investment.

The process of analyzing financially distressed securities starts at the balance sheet. Assets should be valued so that the size of the pie can be estimated. Obligations should then be subtracted from this amount. This task is much more difficult than it appears, however. For a distressed company, asset values are usually a moving target, and getting a handle on their value can be difficult. Furthermore, off-balance sheet liabilities must also be considered.

Finally, Klarman takes the reader through two bankruptcy examples where mispricings occurred which allowed the enterprising value investors the opportunity for excellent returns.

Margin Of Safety: Chapter 11

This chapter examines opportunities at the time of writing that value investors had in the banking sector. In the mid-1980s to early 1990s, many banks were selling for less than book value. During the recession of the early 90s, many thrifts had to be bailed out by the government due to some of the high-risk loans they had offered and due to the general downturn in the US real-estate market...remind you of today?

Apart from the top 10 to 20 largest banks, Wall Street analysts did not follow thrifts. As a result, small and mid-sized shops were trading at inefficient prices, allowing value investors to purchase some companies at a large discount.

Klarman walks the reader through some elements of valuing banks. He considers many banks "unanalyzable", for example if they deal in junk-bonds or complex mortgage securities or other exotic lending instruments. Conservatism is of the utmost importance when valuing companies in this industry, due to the fact that they are highly leveraged and thus already contain a certain amount of risk.

Klarman argues that book value is a good start for valuing a bank, but is usually a conservative estimate of what it is worth. Book value should be adjusted upward for understated assets such as appreciated investment securities, below-market leases, real estate carried below cost and a stable customer/deposit base. Investors must also be on the lookout for items that should be used to adjust book value downward, such as intangible assets, bad loans and poor investments that are carried at cost.

Klarman also notes that there are no sure things in this industry. Asset quality, management discretion, and interest rate volatility play large roles in determining whether an investment will have a good outcome. All investors can do is pick low-risk individual banks with the best prices to their fundamentals and hope for the best. Klarman concludes by taking the reader through the example of Jamaica Savings Bank, by demonstrating the discount to which it traded to its intrinsic value and the resulting profit astute investors accrued.

 

Margin Of Safety: Chapter 10

This chapter contains of a plethora of value investing examples. Klarman details a number of securities where investors who paid attention to fundamentals (e.g. strong businesses masked by unprofitable divisions, or companies trading at discounts to cash etc.) reaped enormous profits.

Klarman believes that investors should look for potential catalysts when making investment decisions. Catalysts are events that cause a stock's value to be recognized, thus resulting in immediate returns to investors who purchased at a discount. A liquidation is an example of a catalyst, and examples are given where such events have returned generous - and quick - positive results for investors (e.g. during bankruptcy events, where securities generally trade at a discount to their recoverable values).

Share buybacks and asset sales also represent partial catalysts, as they can cause a stock to inch closer to its underlying value. More importantly to Klarman, such events signal that management is interested in returning value to shareholders, which bodes well for the future.

Some areas where Klarman believes value investors can indeed find value include: liquidations, complex securities (i.e. securities institutions can't purchase because they don't fit set categories), rights offerings (often offering prices lower than current market value), spinoffs (as they are usually sold by holders of the parents, thus depressing prices immediately) and risk arbitrage (depending on the market's mood, as sometimes the market's exuberance can erode returns).

Margin Of Safety: Chapter 9

Sometimes, there are so many value investments available that the only constraint on the investor is a lack of funds. Most times, however, Klarman finds it difficult to find value investment opportunities. Investors can spend a lot of time reading through financial reports, research reports, and other financial news and end up finding nothing but fairly valued opportunities. Therefore, it is important that the investor look in the right places.

A few of the places Klarman suggests finding investment opportunities include the new-low lists and the largest percentage-decliners lists which are published by major news sources. Klarman also finds that companies whose dividends have been cut or eliminated can also be unduly punished by the market, leaving investment opportunities. Of course, just because a stock shows up on one of these lists does not make it a buy; one still has to go through the valuation process described in previous chapters in order to determine whether it trades at a discount to its fair value.

Klarman also encourages investors to look at what management is doing with respect to the company's stock. Nobody knows the business as well as management does, and so if management is buying that is often a good sign for the stock.

Investors are also encouraged to consider why a stock has been performing poorly (and therefore may make for a good investment). If an investor can pinpoint this reason, he can be more comfortable that he may have found value. If this reason cannot be found, it is possible that the investor is missing some information which the market knows (important lawsuit pending, competitor coming out with similar product etc.).

Margin Of Safety: Chapter 8

Business value cannot be precisely determined, Klarman asserts. Not only do a number of assumptions go into a business valuation, but relevant macro and micro economic factors are constantly changing, making a precise valuation impossible. Although anyone with a calculator or a spreadsheet can calculate a net present value of future cash flows, the precise values calculated are only as accurate as the underlying assumptions.

Klarman argues that investors should instead make use of ranges of values, and in some cases, of applying a base value. He quotes Ben Graham as follows:

The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security. It needs only to establish that the value is adequate—e.g., to pro­tect a bond or to justify a stock purchase—or else that the value is considerably higher or considerably lower than the market price. For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient.

Klarman discusses what he believes to be the only three ways to value a business. The first method involves finding the net present value by discounting future cash flows. Problems with this method involve trying to predict future cash flows, and determining a discount rate. Klarman argues that investors should err on the side of conservatism in making assumptions for use in net present value calculations, and even then a margin of safety should be applied.

The second method is Private Market Value. This is a multiples approach (e.g. P/E, EV/Sales) based on what business people have paid to acquire whole companies of a similar nature. The problems with this method are that comparables assume businesses are all equal, which they are not. Furthermore, exuberance can cause business people to make silly decisions. Therefore, basing your price on a price based on irrationality can lead to disaster. Klarman believes this to be the least useful of the three valuation methods he names.

Finally, Klarman discusses liquidation value as a method of valuation. A distinction must be made between a company undergoing a fire sale (i.e. it needs to liquidate immediately to pay debts) and one that can liquidate over time. Fixed assets can be difficult to value, as some thought must be given to how customized the assets are (e.g. downtown real-estate is easily sold, mining equipment may not be).

When should each method be employed? Klarman argues that they can all be used simultaneously to triangulate towards a value. In some cases, however, one might place more confidence in one method over the others. For example, liquidation value would be more useful for a company with losses that trades below book value, while net present value is more useful for a company with stable cash flows.

Klarman takes the reader through a valuation of Esco, a defense contractor. Using the methods of valuation described in the chapter, he demonstrates that Esco was trading at a severe discount, and subsequently showed that the stock price more than doubled soon after.

Finally, Klarman ends with a discussion of the failures of relying on a company's earnings per share (too easily massaged), book value (not necessarily relevant to today's value) and dividend yield (incentives of management to make yields appear attractive at the expense of the company's future).

Margin Of Safety: Chapter 7

Klarman introduces what he calls the three central elements to a value investing philosophy:

1) A "bottom-up" strategy

2) Absolute (as opposed to relative) performance

3) A risk averse approach

Bottom-Up Investing

In previous chapters it was mentioned that most institutional investors use a top-down approach to investing. That is, they try to forecast macroeconomic conditions, and then select investments based on that forecast. Klarman argues that this method of investing is far too prone to error, and doesn't allow for a margin of safety.

For example, a top-down investor must be correct about the big picture, draw the correct conclusions from that big picture prediction, correctly apply those conclusions to attractive areas of investment, correctly specify specific securities, and finally, beat other investors to the punch who have made the same predictions.

In addition to these challenges, top-down investors are buying based on concepts, themes and trends. As such, there is no value element to their purchase decisions, and therefore they cannot buy with a margin of safety. On the other hand, bottom-up investors can apply a margin of safety and face a limited number of questions, e.g. what is the business worth, what is the downside etc.

Absolute Performance

Institutional investors are judged based on their performance relative to their peers or the market. Thus, if an investment opportunity appears undervalued but the value may not be recovered in the near-term, such investors may shun such an opportunity. Absolute investors don't judge themselves based on their performance to the market, which results in a short-term investing horizon. Instead, they focus on investments that are undervalued, and are willing to wait for that value to come uncovered.

Risk

In the financial industry, returns are expected to correlate with risk. That is, you cannot generate higher returns without taking more risk. Moreover, downside risk and upside potential are considered to have the same probability (an implication of using beta, a measure of a stock's volatility versus the market).

Value investors think of risk very differently. Downside risk and upside potential are not necessarily the same, and value investors seek to exploit this key difference by buying stocks with strong upsides and limited downsides.

Margin Of Safety: Chapter 6

This chapter is dedicated to describing the philosophy of value investing and why it works. The terms used to describe value investing don't require any accounting or finance background, making this an easy read for beginners looking to learn about value investing.

Value investing is described as paying 50 cents for a business worth $1. Warren Buffett's analogy using the maximum allowable weight of a bridge is used to illustrate how this margin of safety works:

"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." 

What allows value investors to apply a margin of safety while most speculators and investors do not? Again Klarman uses a Buffett analogy to illustrate this:

A long-term-oriented value investor is a batter in a game where no balls or strikes are called, allowing dozens, even hundreds, of pitches to go by, including many at which other batters would swing. Value investors have infinite patience and are willing to wait until they are thrown a pitch they can handle—an undervalued investment opportunity.

As a result, Klarman asserts that value investors do not buy businesses they do not understand, nor ones that they find risky. For example, they will avoid technology companies and commercial banks. Value investors will also invest where their securities are backed by tangible assets, to protect them from downside risk.

Because the future is unknown (e.g. a business worth $1 today might be worth 75 cents or $1.25 tomorrow), there is little to be gained by paying $1 for this business. The margin of safety (buying at a discount) is therefore of utmost importance. Since institutions do not buy with a margin of safety, remain fully invested at all times, and trade stocks like pieces of paper with little regard to the underlying asset values, value investors gain an advantage.

Margin Of Safety: Chapter 5

In the previous four chapters, Klarman focused on describing how investors go wrong. Chapter 5 is an introduction to the second part of the book, where Klarman describes the philosophy of value investing.

Klarman quotes Buffett's first two rules of value investing:

1) Don't Lose Money

2) Never Forget Rule #1

While it is easy to say these rules, Klarman said by themselves they don't help investors. Klarman seeks to make it clear that the future is uncertain. Future GDP growth rates, inflation rates, and other relevant factors to stock price returns are always unknown. Furthermore, stocks are junior securities to debt and other firm obligations, making their future values even more uncertain. Stocks are certainly not risk free, but in the following chapters, Klarman seeks to describe strategies investors can follow that will help them follow the above rules.

Margin Of Safety: Chapter 4

In this chapter, Klarman examines the junk bond market in depth to illustrate how Wall Street can create investment fads, only to leave investors much poorer when the tide goes out.

In the early to mid-1980's, Wall Street firms pushed junk bonds on investors, touting the positive historical results of high-yield debt. However, Klarman notes major differences between the debts of fallen angels versus newly issued bonds from fragile companies. 

Since debt from fallen angels trades at a discount to par, downside risk is reduced. At the same time, the potential for capital appreciation is large. Newly issued debt from marginal companies does not share in these characteristics, but that didn't stop Wall Street from pushing this form of debt, nor did it stop investors from ponying up and falling victim to these issues.

The number and size of junk bond issues grew, despite the fact that this asset class was untested by an economic downturn, which should have made investors cautious. Investors were happy to gobble up zero coupon bonds (where the interest accrues to the issuer but is not paid out until the bond comes due) despite the clear risks! It took the downturn of the early nineties to wipe out those who were too eager to pay for assets that were risky.

One way investors were prodded into purchasing such securities were valuation measures based on EBITDA. Rather than considering cash flow or earnings, companies were valued using this accounting measure which doesn't include depreciation expenses. Klarman argues that a company paying its debts from EBITDA is slowly liquidating itself (as it can't make capital expenditures) and leaving itself susceptible to a credit crunch. 

Klarman warns that such fads will undoubtedly occur in the future, and those who are able to avoid them will do well.

Margin Of Safety: Chapter 3

In this chapter, Klarman discusses how the investment world has changed over the last several decades, and how understanding these changes allows investors to earn superior returns. From 1950 to 1990, the institutional share of the market rose from 8% to 45%, and institutions comprise 75% of market trading volume. But the institutions are hampered by a short-term mindset, and Klarman attempts to explain why.

First of all, money managers tend to be rewarded not on what they return to clients, but rather as a percentage of their assets under management. But a larger base of cash actually makes it more difficult to generate returns, thus there is a conflict between what's best for the manager and what's best for the investor.

Institutional investors are also "locked into a short-term relative performance dirby". Frequent comparative rankings among institutional investors forces a short-term mindset, as a long-term view can quickly send a manager to the unemployment line. As a result, these managers act as speculators rather than investors: they try to guess what other managers will do, and try to do it first!

Klarman argues that only the brokers, who benefit from frequent trading, win this derby, as he believes that short-term market fluctuations are random. Institutional investors are also constantly compared (and comparing themselves) to index benchmarks. Due to this relative comparison, they tend to prefer being close to 100% invested, even if things don't look cheap on an absolutely basis, which hurts investors when stocks are expensive.

Klarman also points out that money managers rarely invest their funds along with their clients, making it clear that it's the management firm that wins the conflicts of interest. Klarman would prefer to see the situation as that described by economist Paul Rosenstein:

"In the build­ing practices of ancient Rome, when scaffolding was removed from a completed Roman arch, the Roman engineer stood beneath. If the arch came crashing down, he was the first to know. Thus his concern for the quality of the arch was intensely personal, and it is not surprising that so many Roman arches have survived."

Margin Of Safety: Chapter 2

What's good for Wall Street is not necessarily good for investors, according to Klarman. Because of how Wall Street does business, it has a very short-term focus. For example, Wall Street makes money up-front on commissions (not from long-term performance), therefore the Street will always push for churn and will always push "hot" investments.

Klarman argues that there is nothing fundamentally wrong with this business model. After all, many professionals (consultants, lawyers, doctors) make money in this manner without being responsible for the long-term results. But what's important is that investors recognize this Wall Street bias, or they will be robbed blind.

This business model also encourages very short-term thinking, and a bullish bias. If stocks are going up, Wall Street is able to make more in the form of commissions. Klarman sees evidence of this bullish bias in the percentage of stocks that are recommended by analysts versus those that are deemed "sells".

Klarman provides many examples of Wall Street's short-term bullishness that props up prices of various securities, but where those prices eventually fall dramatically. He advises investors to keep Wall Street's biases in mind when dealing with the Street, and to avoid depending on the Street for advice.

Margin Of Safety, By Seth Klarman: Chapter 1

In the next few weeks, we'll be doing a chapter-by-chapter run-down of Seth Klarman's sought after book, Margin Of Safety. We've discussed Klarman on the site before, as he has consistently demonstrated an ability to generate market beating returns over a long period of time. You can find Klarman's limited edition book selling on ebay for hundreds of dollars.

Chapter 1

Klarman starts out by distinguishing investing from speculating. He uses a Mark Twain quote to illustrate the two times in life when one shouldn't speculate: "when you can't afford it, and when you can!". Speculators buy in the hopes or assumptions that others will want to buy the same asset (be it a painting, a baseball card, or a stock) later, while investors buy the cash flow the investment returns to its owner. (As such, a painting can never be an investment by this definition!)

Examples are provided which describe various speculative bubbles, discussing the faulty logic that first propells speculators to bid up prices followed by the inevitable bursting which destroys the wealth of many.

Klarman suggests that what determines whether an investor will make money in the market or not is his psychological make-up. If he does his own stock analysis and views the prices offered by Mr. Market as an opportunity to buy low and sell high, he will do fine. If Mr. Market's offering prices guide the investor's outlook of what the stock price should be, he should get someone else to manage his money!

Klarman argues that most market fluctuations are the result of day-to-day distortions between supply and demand of particular stocks, not of changes in fundamentals. Investors who take advantage of these distortions by focusing on the fundamentals will be successful. Those who invest with their emotions are sure to fail in the long-run.

Read the rest of the chapters.