Saturday, 7 December 2013

Margin of Safety by Seth Klarman

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.

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