By Seth Klarman
A stock might be the right to own a piece ofa business, and the intrinsic value of the stock was something you couldestimate, but with a margin of safety, you can sleep at night. – Warren Buffett
Have you ever wonderedhow investment decisions are made? Does ‘Margin of Safety’ ring any bell? Well,‘Margin of Safety’, as experts say, is the key to value investing. If valueinvesting is being discussed, Seth Klarman’s name is bound to come into thepicture. Seth Klarman is the author of the book “Margin of Safety- Risk AverseInvesting Strategies for the Thoughtful Investor”, which is being touted as oneof the best value investing classics ever since it was first published in 1991.
In this book, he hascompiled wise and timeless ideas on markets and science of investing. The‘Margin of Safety’ in investment decisions provides a buffer between whatinvestors pay for the stock and what they think it is worth, so that they areprotected against unforeseen events or miscalculations.
In his first and onlybook, Seth Klarman has described his investment philosophy in detail. The bookis out of publication for over a decade now, but one can, sometimes, find it oneBay for around $1,000 since people regard it as a collectible.
Seth Klarman is thechairman of Baupost Group, which is a Boston-based investment firm. He isconsidered to be one of the most successful value investors.
The Baupost Group is oneof the largest hedge funds in the world. It has consistently been one of thetop performing hedge funds and, according to Bloomberg, L.P, is ranked fourthin net gains since inception.
Klarman divides the bookinto three parts. The first part is about where investors make mistakes. Inthis part, the author starts by describing what speculators and unsuccessfulinvestors do. He analyzes how price is important in determining the behavior ofthe market participants. In today’s financial markets, the institutionalinvestors are the dominant players and hence it is necessary to understandtheir behavior to understand the price fluctuations. An important reason toanalyze the behavior of other investors and speculators is that their actionscreate opportunities for value investors.
The market is abattleground where the investors must choose their sides carefully. The firstchoice – consists of majority of investors and speculators. Here the decisionsare based on emotions of greed fear and short-term performance. This isthe wrong choice. The other side involves making decisions based on fundamentalanalysis. Not many people choose this side because it requires commitment andpatience.
According to Klarman,value investing is the only approach that will give positive results in thelong term but with minimum risk. Valueinvesting is not some kind of mystical art that can bepracticed by only a selected few. On the contrary it is very simple. It onlyconsists of determining the value of an underlying security and buying thesecurity at a considerable discount from that value. The biggest challenge isto maintain the required patience and discipline to buy only when the pricesare attractive and to sell when they are not irrespective of the marketsentiments.
However, investors –both individual and institutional – have often displayed their unwillingness totake long term investment decisions based on thorough fundamental analysis. Themain reasons for this are the short-term performance pressures faced by theinstitutional fund managers and the frenzied atmosphere of the market.
The second part of thebook explains the underlying philosophy of value investing. Here, the authoranalyses why most of the investors are risk averse and what are itsimplications. At the core of the philosophy of value investing, is theconcept of margin of safety. Thethree pillars of value investing are:
- A bottom-up approach to investment selection,
- Focus on absolute performance
- Emphasis on return as well as risk.
The primary focus ofmost of the investors is on returns i.e. on how much they can make. Valueinvestors on the other hand focus on risk i.e. on how much they can lose. Thisis because the main goal of value investors is preservation of capital.Hence they incorporate margin of safety in their analysis in order to avoidsizeable losses over a period of time. This margin of safety protects thevalue investors from large losses when the markets are declining.
The third part of thebook focuses on the value investment process. Here the author describesthe research and analytical process i.e. from where the value investors gettheir ideas and how they evaluate them. The author also describes the differentkind of value-investment opportunities like corporate liquidations, spin-offsand risk arbitrage with special focus on thrift conversions and financiallydepressed and bankrupt securities. It also highlights the importance of goodportfolio management and trading strategies. In the end, the author talks abouthow one should go about selecting an investment professional to manage yourmoney.
In the book, the author has given specificexamples of the investments that he has made over the years. The main intentbehind giving these examples seems to demonstrate how value investmentopportunities can arise in different situations.
The book is simple yetprofound. It belongs to the league of legendary books like The “IntelligentInvestor” by Benjamin Graham, “Common Stocks andUncommon Profits” by Philip Fisher and “One Up Wall Street”by Peter Lynch. This book does not have any tables, no formulae or any Greeksymbols. It is just 250 pages of common sense which can be grasped by anyonewho has a basic understanding of investing and accounting. This book is a mustread for anyone who wants to learn value investing; especially, for buddinginvestors, research analysts and investment professionals.
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