Book: Margin of Safety
Author: Seth Klarman
Klarman is called a classic value investor, a term that can be somewhat meaningless, as all investors are by definition seeking value. Nonetheless, he himself counts himself among this clan. In this book, he talks about his investment philosophy. This book is much like The Intelligent Investor by Ben Graham. His book has three parts.
Part I – Where Most Investors Stumble
He says that most investors are primarily oriented toward return—how much they can make, at the expense of little attention to risk—how much they can lose. Value investors, by contrast, have as a primary goal the preservation of their capital; they seek a margin of safety. He draws a line between investment and speculation, saying that investments throw off cash for the benefit of investor (speculations don’t), and that returns from speculations depend exclusively on the vagaries of the resale market.
He says that the market is generator of opportunities, and one of the many reasons is the short-term institutional bias of the Wall Street. He also adds that financial market innovations are good for Wall St but bad for clients. He emphasizes that Wall St is a dangerous places for investors to seek guidance. He also calls out index investing as mindless investing, and he says that more people do this, the more the market will become inefficient, reversing the whole reason indexing was invented to begin with.
He talks about EBITDA method, which he says is a flawed measure and one that leads to over-valuation. EBITDA was a short-cut to get the free cash flow of a company, and was originally done for leveraged companies that were candidates for a take-over. Availability of non-recourse financing changed things by making more cash available to a leveraged company, when compared to a firm that is not as leveraged. The assumption of no capex is also criminal.
Part II – A Value Investment Philosophy
It is very difficult to recover from even one large loss. This example genuinely surprised me – “An investor who earns 16 percent annual returns over a decade, for example, will, perhaps surprisingly, end up with more money than an investor who earns 20 percent a year for nine years and then loses 15 percent the tenth year.” Klarman says that we need to target the downside risk first and then the investment returns.
He says that three critical elements to a value-investment philosophy-
- Bottoms-up strategy (as opposed to top-down, which is vulnerable to error at each step)
- Absolute performance (not relative; requires tolerance of periods of poor performance)
- Risk-averse approach (target risk before returns)
Top-down investors attempt to time the market, which bottom-up investors do not to do.
Klarman says that there’s no one value of a business, as value depends on different expectations; instead we should look for a range. He recommends three methods: NPV, liquidation and relative valuation (as the last resort and useful in only a few cases). NPV method, of course, brings up the need to have a good estimate of discount rate. Klarman says that investors need to take into account his risk profile, riskiness of the investment, and returns available from alternative investments. At times, when interest rates are very low, very high multiples are justified, but valuation based on them is really a bet on interest rates. He says that businesses should be valued based on what oneself, not others, would pay to own.
Part III – A Value Investment Process
In this part, Klarman talks about specific areas that he finds interesting; these include thrift conversions and spin-offs. I don’t summarize them here. Klarman says that when buying a position, one should leave room to average down, when the price falls after the first buy.