I recently finished reading Seth Klarman’s Margin of Safety, one of which I wish I had read earlier! I was able to find an online copy of this famous value investing book. If you’re not familiar with Seth Klarman, he is a billionaire and founder of the Baupost Group, a value investment firm that manages about $30 billion. Before founding Baupost, Klarman worked for Max Heine and Michael Price of the Mutual Series Fund which is now part of Franklin Templeton. There, he was fortunate to learn how to invest unconventionally (value invest) and achieve high returns. After going to Harvard Business School, he helped found Baupost and quickly became known for this “unconventional” strategy of his. He is known as a very conservative investor, often holding large amounts of cash in times of high uncertainty. In these times, he has been known to hold up to 50% cash in the portfolio, waiting to deploy the capital in undervalued securities when the opportunity arises. This obviously takes a certain amount of discipline and patience to wait for these opportunities, as well as a considerable amount of faith from investors for allowing their holdings to be in such a low-return asset for a period of time. After 9 years of managing Baupost, he decided to impart some of his investment wisdom on the world by writing Margin of Safety: Risk Averse Value Investing Strategies for the Thoughtful Investor. Today, the book is out of print and can be bought for upwards of $1,500 for a copy! If you’re interested in getting a copy, I would recommend typing in “Margin of Safety pdf” on Google and go with the free version from there. Although, one may argue that the $1,500 could be a bargain based on the insights you can gain from this book :-).
The book is split into three sections: 1) Where Most Investors Stumble 2) A Value Investment Philosophy and 3) The Value-Investment Process. This post is focusing on the first section, covering a few chapters on “Where Most Investors Stumble”. This post largely will consist of anecdotes from Mr. Klarman which are all quoted and underlined, with a few comments from myself.
Mr. Klarman recommends one path, and one path only for investors follow. And that is a value-investment philosophy. Klarman explains that value investing is the strategy of investing in securities trading at an appreciable discount from underlying value. This strategy has a long history of delivering excellent investment results with very limited downside risk. In other words, Klarman makes asymmetric bets, where the down side is much less than the upside potential.
“Investors adopt many different approaches that offer little or no real prospect of long-term success and considerable chance of substantial economic loss.”
“Ideally this will be considered, not a book about investing, but a book about thinking about investing.”
“There is nothing esoteric about value investing. It is simply the process of determining the value of the underlying a security and then buying it at a considerable discount from that value. It is really that simple. The greatest challenge is maintaining the requisite patience and discipline to buy only when prices are attractive and to sell when they are not, avoiding the short-term performance frenzy that engulfs most market participants.”
Speculators and Unsuccessful Investors
A key theme in value investing which can be found in many of the great investors’ writings (Graham & Dodd, Buffett, Munger, etc.) is knowing the difference between an investor and a speculator, and ensuring you are partaking as the former and not the latter. The investor understands that stock represents the fractional ownership of an underlying business. Investors trade based on large differentials between current price and intrinsic value of a business (based on a conservative estimate). Speculators do not view stock as ownership of a business, but as a paper with no underlying value. Speculators trade stock based on what they believe other people will be doing in the market.
“Investors believe that over the long run security prices tend to reflect fundamental developments involving the underlying businesses….Speculators, by contrast, buy and sell securities based on whether they believe those securities will next rise or fall in price… Speculators are obsessed with predicting–guessing– the direction of stock prices.”
One of the great examples Klarman includes is the story of trading Sardines and eating sardines. I will include because it truly captures the essence of his point:
“There is the old story about the market craze in sardine trading when the sardines disappeared from their traditional waters in Monterey, California. The commodity traders bid them up and the price of a can of sardines soared. One day a buyer decided to treat himself to an expensive meal and actually opened a can and started eating. He immediately became ill and told the seller the sardines were no good. The seller said, “You don’t understand. These are not eating sardines, they are trading sardines.”
Klarman explains that the difference between the successful and the unsuccessful investor is that the successful investors tend to be unemotional, allowing for the greed and fear of others to play into their hands. Viewing the market correctly is a key factor in investment success. Klarman views the market as Warren Buffett does by knowing it as Mr. Market (this is how Benjamin Graham taught it). He tells us that Mr. Market is a trickster. Some investors will look to Mr. Market for investment guidance, “when in reality Mr. Market knows nothing, being the product of the collective action of thousands of buyers and sellers who themselves are not always motivated by investment fundamentals.” Because of this, the successful investor can take advantage of Mr. Market. When Mr. Market is being emotional and prices fluctuate wildly, it is likely that prices will depart from their true value. Every day, Mr. Market will come to you with a new price, it is your choice to take advantage of when Mr. Market becomes emotional and to turn Mr. Market down when he is too optimistic or happy.
We all hear about people who are trading every day (remember, we call these speculators). Making money quickly is what the majority of people want, but making quick money is often through speculation, which isn’t the best long-term strategy to build wealth. In reality, it’s often a loss-making strategy. Warren Buffett is often quoted, “only when the tide goes out do you discover whose been swimming naked.” In other words, everyone’s holdings are rising in a bull market, it isn’t until the market turns bearish that problem’s with one’s investments are truly realized. If you are investing you are likely to already know what you are investing in well. If you are speculating, the opposite would likely be true. I think Seth Klarman says this even better in the following quote.
“There is great allure to treating stocks as pieces of paper that you trade. Viewing stocks this way requires neither rigorous analysis nor knowledge of the underlying business. Moreover, trading in and of itself cash be exciting and, as long as the market is rising, lucrative. But essentially it is speculating, not investing. You may find a buyer tat a higher price-a greater fool–or you may not, in which case you yourself are the greater fool. Value investors pay attention to financial reality in making their investment decisions.”
“Security prices sometimes fluctuate, not based on any apparent changes in reality, but on changes in investor perception.”
Another point Klarman makes is that collectibles are not investments. They do not generate and cash flow, and therefore do not have any true underlying value. The only cash the collectible will generate is from the eventual sale, and therefore a future buyer is dependent on their prospects for resale. The value derived from collectibles is solely dependent on supply and demand, which is subject to significant changes in taste and preferences.
“Needless to say, investors are able to distinguish Pepsico from Picasso and understand the difference between an investment and a collectible.”
“Louis Lowenstein has warned us not to confuse the real success of an investment with its mirror of success in the stock market.”
The Nature of Wall Street Works Against Investors
I’m not going to spend very much time on this chapter. It’s something we are all aware of, but something that we much always keep in mind. As Klarman tells us, Wall Street is something we cannot avoid, but must be very aware of as we deal with them in our work. Wall Street does perform important functions for our economy: they raise capital for expanding businesses and (sometimes) provide liquidity to markets). Moreover, “we must remember that Wall Streeters get paid primarily for what they do, not how effectively they do it.” These firms get paid large up-front fees and commissions. Often, these commissions are based on the size of a deal or the frequency of trades made. There are conflicts of interest for those who manage our money, which is mentioned in a little bit more detail further in this post. Wall Street is short-term focused and often put their own firms interest first – not their clients. One thing that I thought was very interesting when reading was Wall Street’s bullish bias and what this means for the market. Because of their bullish bias, research they publish is strongly oriented toward buy rather than sell recommendations. After all, there is more brokerage business in buying rather than selling. Over the long-term, what does this mean for the market and clients? These two quotes explain well.
“Many of the factors that contribute to a bullish bias can cause the financial markets, especially the stock market to become and remain overvalued. Correcting a market overvaluation is more difficult than remedying an undervalued condition.”
“Since security prices reflect investors’ perception of reality and not necessarily reality itself, overvaluation may persist for a long time.”
The Institutional Performance Derby: The Client is the Loser
Over the past few decades, trillions of dollars have poured into growing pools of retirement and endowment funds. As of the time of Margin of Safety’s writing, institutional ownership in all publicly traded U.S. securities increased from 8% in 1950 to 45% in 1990. Today, this number has surely increased. Despite this book being written 16 years ago, all of it’s insights still hold true today despite the fund management business growing preposterously. There’s something about those value investment books, eh? We’re all still reading the 1934 edition of Security analysis.
Back to the point – Billions and even trillions of dollars of hard-earned money of the average individual are under management at these large institutional funds and their money is often whipped from one investment to another with little research or analysis. “The prevalent mentality is consensus, groupthink. Acting with the crowd ensures an acceptable mediocrity; acting independently runs the risk of unacceptable underperformance.”
Often, the fund manager is at odds with the client, because their incentives are not aligned. If you want to see someone with truly aligned incentives, read my post on Warren Buffett’s Ground Rules here. In the investment management business, fund managers care about the size of their fund, because they often generate a flat fee based on what they manage. Their incentive is to expand their managed assets to generate more fees. Their minds are set on a short-term, relative-performance derby. They are often checking their hourly performance and how they are comparing to competitor funds. Because of their focus on relative performance to others, they are often acting as speculators trying to guess what others are going to do. In other word’s they are trying to get ahead of the crowd, rather than choosing investments based on sound, independent judgement of an investment’s characteristics.
Additionally, these large institutional investors are at a disadvantage because of the size of their fund. As fund size increases, the return per dollar invested declines as total assets increase. This makes them target only a certain subset of securities, usually large-cap securities. If a manager has $1 billion in funds, they likely have a limit for no holding being greater than 5% of total assets ($50 million). They will do this to avoid any liquidity issues. This implies that they must own shares of companies with a minimum market capitalization of $1 billion each. As of 1991, there were only 559 companies with this size of market capitalization. These limits leave them with a small universe of opportunities. This number has also grown today, but the point is still true today.
As mentioned before, Klarman likes to keep cash in his portfolio, and especially a significant amount during a bull market that has gone on for awhile. Unlike Seth Klarman, institutional investors are often required to be fully invested at all times. They argue that their clients are picking their market timing, and therefore their task is stock picking. Klarman does acknowledge that remaining fully invested at all times does simplify the investment process, but “unfortunately the important criterion of investment merit is obscured or lost when substandard investments are acquired solely to remain fully invested.” These investments can generate sub-par returns or at-worst create a high opportunity cost, meaning you are foregoing the next good opportunity to invest right now becuase they must remain fully invested at all times.
Fund managers often “window dress,” where they make their portfolio look good for quarterly reporting purposes by selling shares with significant underperformance during their quarter. They also use practices such as “tactical asset allocation, portfolio insurance and program [which] share to a greater or lesser extent the same disregard for investing based on company-by-company fundamentals.” Additionally, there is a large trend in indexing that has continued since the 90’s.
On indexing, there are many institutional investors believe in the efficient-market hypothesis, which holds that all information about securities is disseminated and becomes fully reflected in security prices simultaneously. If this is true, there is no point to try to beat the market. They believe you should just own the market. Value investing opposes this viewpoint, believe that financial markets are not efficient. A funny thing, clients will pay managers to invest their funds in index funds for a fee, when they could simply do this themselves very easily for little to no-fee. For someone who doesn’t have the time to research and invest in companies based on fundamentals, then I do advocate investing in a low-cost index fund.
While this post didn’t cover every significant point by Klarman, it covered a handful of them that I thought were important that you could learn from too!
What do you readers think are the major pitfalls you or other investors stumble into? What are your thoughts on investing vs. speculating? How about fundamental investing vs. indexing?
Thanks for reading!
Chris @ Sleepy Capital