04: Margin of Safety

Margin of Safety

Seth Klarman

The fourth book in the Investing Book Highlights series is Margin of Safety by Seth Klarman. This book delves into Risk-Averse Value Investing Strategies for the Thoughtful Investor. Klarman delivers practical insights for investors via the well versed adage of buying securities at a discount to their current underlying value and holding them until their value is realized.

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TOP TEN JOTS

10. All market fads come to an end.

• "Investors must never forget that Wall Street has a strong bullish bias, which coincides with its self-interest." states Klarman. More transactions are made during a bull market than a bear market and those transactions influence the amount of income Wall Street workers receive.
• Security prices going too far up and then too far down is a cycle that often gets repeated. Before buying into a security, have a margin of safety to protect you from the downside risk.

9. Acting with the crowd ensures an acceptable mediocrity; acting independently runs the risk of unacceptable under-performance.

• Most money managers consider mediocre performance acceptable since they can satisfy most of their clients and keep retention rates high.
• Indexing guarantees matching the performance of the securities in the index (although it also guarantees not outperforming it)
• Klarman declares "Money managers are indifferent to whether the index rises or falls in value, other than to the extent that fees are based on total managed assets valued at market prices."

8. No one knows what the market will do; trying to predict it is a waste of time, and investing based upon that prediction is a speculative undertaking.

• The two most common type of market players are the investors and the speculators.
• Investor usually buy into a great business that can generate cash but is being offered at a discount while speculators play the "greater fool game" of buying overvalued businesses in hope that someone will buy it at a greater price.
• Klarman emphasizes, "Value investors are in a position to take advantage of Mr. Market's irrationality. Speculators mistakenly look to Mr. Market for investment guidance and buy high and sell low."

7. Most of the major money management firms consider only large-capitalization securities for investment. 

• The flexibility of institutional investors is frequently limited by a self-imposed requirement to be fully invested at all times even if substandard investments have to be added to their portfolio.
• Ample investment opportunities may exist in the securities that are excluded from consideration by most institutional investors. Mid and small capitalization securities offer investors a chance to buy a growing and/or emerging business that is overlooked and undervalued. 

6. The opportunity cost of illiquidity is high.

• Most portfolios should maintain a balance of liquid and illiquid investments, opting for greater illiquidity when the market compensates investors well for bearing it.
• When your portfolio is completely in cash, there is no risk of loss. There is also, however, no possibility of earning a high return. 
• Having liquid assets during a market recession or correction reduces opportunity costs as bargains can be scooped up readily.
  
  

5. Value investing offers a good possibility of investment success with limited risk.

• Investing into a security is usually better when there is inherent value in the current price.
• Buying at a considerable discount is the best way to insure that you aren't overpaying.
• The best time to be a value investor is when the market is falling so that you can seek the considerable discount that often besets itself.
• Value investing does entail risk since risk is something that cannot be avoided but it does try to curtail it by purchasing securities at a mark down.

4. Avoiding loss should be the primary goal of every investor.

• Klarman advises all of the following:
• Not losing money means that over several years an investment portfolio should not be exposed to appreciable loss of principal.
• The actual risk of a particular investment cannot be determined from historical data. It depends on the price paid.
•  Financial catastrophes can and do occur. Look at the Great Recession (2008) and the dot-com bubble (2000) as examples.

3.  Greater risk does not guarantee greater return.

• Klarman and Howard Marks both agree that risk and return are not necessarily positively correlated and in fact risk can erode return by causing losses.
• In inefficient markets it is possible to find investments offering high returns with low risk.
• "We do not and cannot know all the risks of an investment so we should strive to invest at a discount. The bargain element helps to provide a cushion for when things go wrong." claims Klarman.

2. Business valuation

• "Investors should not fool themselves into believing they are capable of greater precision than experts when buying marketable securities based only on limited, publicly available information." states Klarman.
• To perform a business valuation you must predict the future, yet the future is not reliably predictable. This suggest that conservative projections and substantial discounts are the best way to invest in a business.
• An investor is better off knowing a lot about a few investments than knowing only a little about each of a great many holdings. 

1.   The importance of 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." states Klarman.
• The cheapest security in an overvalued market may still be overvalued.
• The disciplined pursuit of bargains provides a margin of safety and a risk-averse approach.

What do you think of Klarman's ideas? Please comment below. If you have already read it, please let me know which were the most important for you.