During my two-week cruise
to New Zealand (in which I surprisingly didn’t see a single sheep), I was
delighted to find time to finish off Benjamin Graham’s seminal value investing
treatise, The Intelligent Investor (fourth revised edition) and Seth
Klarman’s 1991 book, Margin of Safety: Risk-Averse Value Investing
Strategies for the Thoughtful Investor. I thought I’d briefly share
some of my thoughts on the latter.
Although he is now deemed
to be one of the legendary value investors, Klarman hasn’t always been so
popular. His first and only book so far, Margin of Safety was a
commercial failure and has since gone out-of-print after an original run of
5,000 copies. However, as Klarman continued to produce superb results at The
Baupost Group, the hedge fund he co-founded in 1982, people soon started
searching for the secrets to his success. The laws of supply and demand have
thus caused the price of his elusive work to skyrocket - on Amazon, a used copy
will currently set you back at least $2,000 while new copies start from $3,800.
You would be hard pressed to find this book in a library as most copies have
been stolen. So Mr Klarman, I hope you’ll forgive me for opting to download a
digital copy of your book.
Seth Klarman is no doubt an
excellent value investor, but if I am honest, I didn’t find Margin of Safety
to be an exceptional read. It seems unclear who his target audience is: most
beginners will get lost as Klarman generally assumes prior knowledge of
concepts and jargon such as discounting cash flows, while at a relatively
paltry 250 pages or so, more advanced investors will probably find little to
dig their teeth into. There really isn’t anything that you cannot find
somewhere else. And unlike writers such as Peter Lynch, there is no humorous,
conversational tone to be found within these pages. Having said all that, I
still found Margin of Safety to be well worth my time as it was thought
provoking to consider the nuances of Klarman’s approach, and it’s always
interesting to read about case studies. Moreover, I was pleased that a few
chapters in the final third of the book resemble the ‘special situation’
investing that Joel Greenblatt brilliantly describes in his title You Can Be
a Stock Market Genius. Klarman gives readers a taste of the opportunities
available in corporate liquidations, ‘complex securities’, rights offerings,
risk arbitrage, spinoffs, thrift conversions, and financially
distressed/bankrupt securities. In being able and willing to take advantage of
these more obscure investments, I think this is where Klarman really shines as
an investor, and it is an area that I would like to better understand.
While all value investors
share the common foundation of trying to purchase undervalued securities, there
is considerable variation in the exact implementation of this approach.
Although he often cites Warren Buffett, Klarman is more of a cautious Benjamin
Graham style investor than a modern day Buffett as he gravitates towards
tangible asset plays and discloses his wariness for the value of intangible
assets. In fact, his values (if you’ll excuse the pun) are so similar to Graham
that he had the honour of being the lead editor and a commentator on the sixth
edition of Benjamin Graham’s Security Analysis. Klarman has notched up
circa 20% annual returns since inception of Baupost Group, taking it from
assets of $30 million in 1982 to $29.4 billion in 2012, and remarkably done so
whilst often holding high levels of cash, another indication of his conservative
style. On the debatable subject of how to value businesses, Margin of Safety
outlines three different valuation techniques that he finds useful: net present
value (discounting cash flows), liquidation value (what would be left for
investors if the company were dismantled and the assets sold), and ‘stock
market value’ (looking at prices on equity and debt markets to approximate
value in some situations). He also mentions ‘private-market value’, which is
where investors look at what kind of multiples that sophisticated, prudent
businesspeople have recently paid to acquire similar businesses, however, he
cautions that these multiples are not necessarily rational and prefers that
investors determine what they themselves would pay instead.
Unfortunately, like many
parts his book, by cramming the important subject of valuation in just one
chapter, Klarman doesn’t provide as much discussion or as many examples as I
would have liked. For instance, he is extremely vague in describing what rate
to discount cash flows at, other than saying that there is no single correct
discount rate, and that it should be influenced by an investor’s preference for
future dollars, the risk of the investment, and interest rates. Readers have no
way of determining whether 5%, 10% or even 50% is appropriate, other than a
sole case study where he applies a 12% and 15% rate without justification as to
how he arrived at those numbers. Reflecting the indeterminate nature of
discount rates, Klarman explains that it is impossible to come up with a
precise value for a stock, but this is unnecessary if investors buy at a
significant discount to a range of values obtained through one or more of the
above valuation techniques. This is the crucial value investing principle of
the margin of safety first proposed by Benjamin Graham, which Klarman has aptly
used as the title of his book.
Throughout Margin of
Safety, Klarman advocates targeting absolute-performance and decries
relative-performance, going so far as to declare ‘value investing is
absolute-performance-, not relative-performance oriented’. Although I can see
the logic in pursuing absolute returns, I have to disagree with Klarman here.
If you decide to actively select investments in the share market, it makes
sense to be measuring yourself against the ‘average return’ easily obtainable
by buying into an index fund. An annual return of 5% over the long term may
seem satisfactory to absolute oriented investors, but if everyone else is
achieving 10%, I would argue that you have done a poor job and wasted your
time, value investor or not. Buffett shares this view: ‘Relative results are
what concern us: Over time, bad relative numbers will produce unsatisfactory
absolute results.’ And speaking of index returns, Klarman also says, ‘I believe
that indexing will turn out to be just another Wall Street fad’, calling it
‘both lazy and shortsighted’. Well he has certainly been proven wrong in the 22
years since he wrote that, and for good reason - endless studies show that over
time, the vast majority of investment professionals underperform the broad
market indices after fees are accounted for, and therefore an ordinary person
is almost guaranteed to beat them by simply purchasing a low cost index fund.
Once again, Buffett has the good sense to agree with me here.
Despite the nitpicking, I
have much respect for Klarman and can suggest his book to intermediate or
experienced investors as a decent rundown of the value investing approach if they are in need of some investment reading. I’ll be
adding both Margin of Safety and The Intelligent Investor to my
recommended reading page, and I leave you with a selection of quotes from Margin
of Safety that were interesting or insightful to me.
“To some extent value, like
beauty, is in the eye of the beholder; virtually any security may appear to be
a bargain to someone.”
“Unlike return, however,
risk is no more quantifiable at the end of an investment than it was at its
beginning.”
“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.”
“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.”
“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.”
“Investors must recognise
that while over the long run investing is generally a positive-sum activity, on
a day-to-day basis most transactions have zero-sum consequences. If a buyer
receives a bargain, it is because the seller sold for too low a price.”
“In times of general market
stability the liquidity of a security or class of securities can appear high.
In truth liquidity is closely correlated with investment fashion. During a
market panic the liquidity that seemed miles wide in the course of an upswing
may turn out only to have been inches deep.”
“Investing, it should be
clear by now, is a full-time job. Given the vast amount of information available
for review and analysis and the complexity of the investment task, a part-time
or sporadic effort by an individual investor has little chance of achieving
long-term success.”
