Margin of Safety by Seth Klarman

Summary

A great explanation of value investment principles, valuation methods and how to avoid investment failure. A shorter, easier and, for most people, more useful read than The Intelligent Investor.

Key Takeaways

Buy and sell decisions must be based on the prices of securities compared with their perceived values.
The ideal investment: ongoing, profitable, and growing businesses with share prices considerably below conservatively appraised underlying value.
Mr. Market is a creator of investment opportunities (where price departs from underlying value), not someone to look at for investment guidance.
Business valuation is done by analyzing the cash flow of the business.
- NPV analysis: the discounted value of all future cash flows that a business is expected to generate.
- Liquidation value
  - Net-net working capital: net working capital minus all long-term liabilities.
- Stock market value: an estimate of the price at which a company, or its subsidiaries considered separately, would trade in the stock market.
Discount rate: there is no “correct” level of discount rate. Many investors use 10 percent.
Use three scenarios (optimistic, conservative, pessimistic) and do a sensitivity analysis.
Buy: best absolute values among those that are currently available.
Sell: depends on the alternative opportunities that are available and the realization of underlying value.
Dollar-cost-average into and out of investments.
Don’t lose money. Preservation of capital is the primary goal.
The risk of an investment depends on the price paid.
- How to reduce risk:
  - Diversify adequately
  - Hedge when appropriate
  - Invest with a margin of safety
  - Have investments with a catalyst in your portfolio
How to be a successful investor:
- Most important: develop the appropriate reaction to price fluctuations.
  - Resist fear
  - Resist greed
- Don’t invest in businesses that you cannot readily understand or ones you find excessively risky.
- Student of the game: learn from every pitch, those at which they swing and those they let pass by.
- Have infinite patience and are willing to wait until you are thrown a pitch you can handle – an undervalued investment opportunity.
- Have a long-term investment horizon.

What I got out of it

Different valuation methods and how to combine them to approximate the value of a business and, subsequently, the margin of safety of the investment decision.
Portfolio management and the timing with which to buy and sell stocks.

Summary Notes

How To Invest

Assumptions And Investment Philosophy

Value investing: buy and sell decisions must be based on the prices of securities compared with their perceived values.
Over the long-run security prices tend to reflect fundamental developments involving the underlying business.

Numbers are not an end in themselves; they are a means to understanding what is really happening in a company.

An analytical tool must be consistent in its valuations.

Mr. Market

Mr. Market is a creator of investment opportunities (where price departs from underlying value), not someone to look at for investment guidance.

The Ideal Investment

The attraction of some value investments is simple and straightforward: ongoing, profitable, and growing businesses with share prices considerably below conservatively appraised underlying value.

What NOT To Invest In

Investments throw off cash flow for the benefit of the owners; speculations do not.

Collectables, such as art, antiques, rare coins, and baseball cards are not investments but rank speculations.
Collectables throw off no cash flow.

The only possible exceptions to this cash flow test are precious metals, such as gold, which is a widely – and throughout history – recognized store of value.

Other precious metals and gems have a less-established value than gold but might be considered by some to be a similar type of holding.

How To Profit From A Stock

Free cash flow generated by the underlying business, which eventually will be reflected in a higher share price or distributed as dividends
An increase in the multiple that investors are willing to pay for the underlying business as reflected in a higher share price
A narrowing of the gap between share price and underlying business value

Stock and Business Valuation

Traditionally, investors have evaluated public companies on reported earnings, but private companies on free cash flow. The best way to value a stock, however, is to analyze the cash flows of the underlying business.
But keep in mind: estimating future cash flow for a business is usually a guessing game.

Methods to value a business:

An analysis of going-concern value, known as net present value (NPV) analysis. NPV is the discounted value of all future cash flows that a business is expected to generate. Two ways to apply it:
- Calculate the present-value of a business and use it to place a value on its securities.
- Calculate the present-value of the cash flows that security holders will receive: interest and principal payments in the case of bondholders and dividends and estimate future share prices in the case of stockholders.
Liquidation value: the expected proceeds if a company were to be dismantled and the assets sold off. The liquidation value of a company’s fixed assets can be difficult to determine. It’s generally a worst-case assessment.
- Approximation with net-net working capital. Net working capital consists of current assets (cash, marketable securities, receivables, and inventories) less current liabilities (accounts, notes, and taxes payable within one year.) Net-net working capital is defined as net working capital minus all long-term liabilities. Even when a company has little ongoing business value, investors who buy at a price below net-net working capital are protected by the approximate liquidation value of current assets alone. Ongoing business losses can, however, quickly erode net-net working capital.
Stock market value: an estimate of the price at which a company, or its subsidiaries considered separately, would trade in the stock market. The assumption is that business people know what they are doing. So, it’s less reliable than the other two, this method is only occasionally useful as a yardstick of value.

When to use each method:

Net present value: valuing a high-return business with stable cash flows.
Liquidation analysis: valuing an unprofitable business whose stock trades well below book value.

The discount rate with NPV analysis:

A discount rate is the rate of interest that would make an investor indifferent between present and future dollars.
All-purpose discount rate: 10 percent. But it’s not always a good choice.
There is no “correct” level of discount rate.

The discount rate with liquidation value depends on whether the inventories consist of finished goods, work in process, or raw materials, and whether or not there is the risk of technological or fashion obsolescence.

Business metrics to avoid or watch out for:

EBITDA is analytically flawed and often results in the (chronic) overvaluation of businesses.
Earnings and book value have a place in securities analysis but must be used with caution and as part of a more comprehensive valuation effort. What something cost in the past is not necessarily a good measure of its value today.
- Inflation, technological change, and regulation, among other factors, can affect the value of assets in ways that historical cost accounting cannot capture.
- Reported book value can also be affected by management actions.
- The choice of accounting method for mergers – purchase or pooling of interests – can affect report book value.
If capital spending is less than depreciation over a long period of time, a company is undergoing gradual liquidation.

What to do about the possibility of a decline in business value:

Since investors cannot predict when values will rise or fall, valuation should always be performed conservatively, giving considerable weight to worst-case liquidation value as well as to other methods.
When fearing deflation, demand a greater than usual discount between price and underlying value. This means that normally selective investors would probably let even more pitches than usual go by.
The prospect of asset deflation places heightened importance on the time frame of investments and on the presence of a catalyst for the realization of underlying value. In a deflationary environment, if you cannot tell whether or when you will realize underlying value, you may not want to get involved at all. If underlying value is realized in the near-term directly for the benefit of shareholders, however, the longer-term forces that could cause the value to diminish become moot.

Scenario Planning and Sensitivity Analysis

Have:

An optimistic scenario
A conservative scenario
A pessimistic scenario

Use these scenarios to perform a sensitivity analysis in which you evaluate the effect of these different cash flow forecasts and different discount rates on present value.

How to deal with the analytical necessity to predict the unpredictable?
Conservatism.

When To Buy

Price decline alone does not make a security a bargain; an appreciable discount from underlying value is also required.
Being a good absolute value alone, however, is not sufficient. Investors must choose only the best absolute values among those that are currently available.

When To Sell

There is only one valid rule for selling: all investments are for sale at the right price.
Decisions to sell, like decisions to buy, must be based upon underlying business value. Exactly when to sell – or buy – depends on the alternative opportunities that are available.

No investment should be considered sacred when a better one comes along.

Understanding and Managing Risk

The risk of an investment depends on the price paid.
The risk of an investment is described by both the probability and the potential amount of loss.
In most cases no more is known about the risk of an investment after is it concluded than was known when it was made.

How to counteract risk:

Diversify adequately
Hedge when appropriate
Invest with a margin of safety

Misunderstanding of risk:

A positive correlation between risk and return would hold consistently only in an efficient market.
Past security price volatility does not reliably predict future investment performance (or even future volatility) and therefore is a poor measure of risk.

Portfolio Management

Reducing risk within a portfolio:

Have sound buying and selling strategies
Diversify
- Diversification is not how many different things you own, but how different the things you do own are in the risks they entail.
- Ten to fifteen holdings are sufficient
Hedge when appropriate
Owning securities with catalysts for value realization

Although specific investments have a beginning and an end, portfolio management goes on forever.

Investing is in some ways an endless process of managing liquidity. The investor is constantly challenged to put cash to work, seeking out the best value available.
A mitigating factor in the tradeoff between return and liquidity is duration.

This portfolio liquidity cycle serves two important purposes:

Portfolio cash flow can reduce an investor’s opportunity costs.
The periodic liquidation of parts of a portfolio has a cathartic effect.

How To Be A Value Investor

What Is Value Investing

Value investing is the discipline of buying securities at a significant discount from their current underlying values and holding them until more of their value is realized.

It has a long history of delivering excellent investment results with very limited downside risk.

Assumption: over time the general tendency is for underlying value either to be reflected in securities prices or otherwise realized by shareholders.

Requirements To Be A (Successful) Value Investor

Don’t invest in businesses that you cannot readily understand or ones you find excessively risky.
Student of the game: learn from every pitch, those at which they swing and those they let pass by.
Unusually strict discipline
- Have infinite patience and are willing to wait until you are thrown a pitch you can handle – an undervalued investment opportunity.
Not influenced by the way others are performing, but motivated only by their own results.
A long-term investment horizon
Standing apart from the crowd, challenging conventional wisdom, and opposing the prevailing investment winds
- A value investor may experience poor, even horrendous, performance compared with that of other investors of the market as a whole during prolonged periods of market overvaluation.
Hard work

The hard part is discipline, patience, and judgment. Investors need discipline to avoid the many unattractive pitches that are thrown, patience to wait for the right pitch, and judgment to know when it is time to swing.

Value Investing Philosophy

The primary goal: the preservation of capital.

A bottom-up strategy, entailing the identification of specific undervalued investment opportunities.
Absolute performance, not relative performance-oriented.
- Absolute-performance-oriented investors are willing to hold cash reserves when no bargains are available.
A risk-averse approach; attention is paid as much to what can go wrong (risk) as to what can go right (return).
Seeking a margin of safety, allowing room for imprecision, bad luck, or analytical error in order to avoid sizable losses over time.
- A margin of safety is necessary because valuation is an imprecise art, the future is unpredictable, and investors are human and do make mistakes.

Advantages Of Bottom-Up Investors

Able to identify simply and precisely what they are betting on.
Fewer uncertainties
- What is the underlying business worth
- Will that underlying value endure until shareholders can benefit from its realization
- What is the likelihood that the gap between price and value will narrow
- Given the current market price, what is the potential risk and reward?
Can easily determine when the original reason for making an investment ceases to be valid, reevaluate the situation and, if appropriate, sell the investment.
- When the underlying value changes
- When management reveals itself to be incompetent or corrupt
- When the price appreciates to more fully reflect underlying business value

How To Become A Successful Investor

How To Achieve Investment Success

Most important: develop the appropriate reaction to price fluctuations.

Resist fear – the tendency to panic when prices are falling
Resist greed – the tendency to become overly enthusiastic when prices are rising

Refrain from purchasing a “full position” in a given security all at once. Dollar-cost-average in.
If, prior to purchase, you realize that you are unwilling to average down, then you probably should not make the purchase in the first place.

Avoid where others go wrong.

When one should not speculate: when he can’t afford it and when he can. – Mark Twain

What to do when the price of a stock drops: if the security were truly a bargain when it was purchased, the rational course of action would be to take advantage of this even better bargain and buy more.

Avoiding losses is the most important prerequisite for investment success.
You are more likely to do well by achieving consistently good returns with limited downside risk than by achieving volatile and sometimes even spectacular gains but with considerable risk of principal.

An investor who earns 16 percent annual returns over a decade, for example, will, perhaps surprisingly, end up with more money than an investor who earns 20 percent a year for nine years and then loses 15 percent in the tenth year.

Have a margin of safety: purchase securities at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable, and rapidly changing world.

It is difficult, if not impossible, to determine precisely what a stock is worth. It is far simpler to determine that it was worth considerably more than the market price.
The nice thing is that one doesn’t have to know exactly what a stock is worth. When a price reflects disaster; any other outcome seems certain to yield a higher price.

The pricing of large-capitalization stocks tends to be more efficient than that of small-capitalization stocks, distressed bonds, and other less-popular investment fare.
Better investment opportunities exist in the securities that are excluded from consideration by most institutional investors.

Know that business value cannot be precisely determined.
The discrepancy between the buyer’s and the seller’s perceptions of value can result from such factors as differences in assumptions regarding the future, different intended uses for the asset, and differences in the discount rates applied.

Try to find out why a bargain has become available. When the reason for the undervaluation can be clearly identified, it becomes an even better investment because the outcome is more predictable.

If in 1990 you were looking for an ordinary, four-bedroom colonial home on a quarter acre in the Boston suburbs, you should have been prepared to pay at least $300,000. If you learned of one available for $150,000, your first reaction would not have been, “What a great bargain!” but, “What’s wrong with it?”

Learn to live with less than complete information.
Don’t confuse the capability to make precise forecasts with the ability to make accurate ones.

How To NOT Achieve Investment Success

Be dominated by emotion.

Follow Wall Street: it has a strong bullish bias, pursues maximization of self-interest and is short-term oriented.

Not recognizing and joining Wall Street fads: their success is a self-fulfilling prophecy:

Buyers bid up prices
This justifies their original enthusiasm, further bidding up prices
When prices peak and start to decline, buyers turn into sellers and aggravate an oversupply problem
People head for the exit…which usually leads to another fad.

Listen to (all) money managers and don’t recognize that most are paid as a percentage of total assets under management – and not performance. They are incentivized to expand managed assets or to trade the hot stocks and winners of the day.

Not recognizing that price fluctuations are random.

Attempting to outperform the market – it’s futile.

Not understanding that the return per dollar invested declines as total assets increase.

Failure to understand the institutional investment mentality:

Institutions dominate financial-market trading.
Better investment opportunities exist in the securities that are excluded from consideration by most institutional investors.

Not realizing that bidders who are able to defer the financial day of reckoning far into the future are not constrained by financial reality.

Failure to realize that a promise is only as good as the entity that makes it.

Having no margin of safety and investing based on a top-down approach: a concept, theme, or trend – i.e. without determining the underlying value.

Investment Niches

Value investing niches can be divided into three categories:

Securities selling at a discount to break-up or liquidation value
Rate-of-return situations
Asset-conversion opportunities

Specific niches:

Corporate liquidations
Complex securities: unusual contractual cash flow characteristics
Rights offerings
Risk arbitrage
- It differs from the purchase of typical securities in that gain or loss depends much more on the successful completion of a business transaction than on fundamental developments at the underlying company. The principal determinant of investors’ return is the spread between the price paid by the investor and the amount to be received if the transaction is successfully completed.
Spinoffs
Bond and stock intermarket arbitrage
Bankruptcies and financially distressed companies

Bankruptcies

When investing in bankruptcies, consider:

Compare price to value. Investors in distressed or bankrupt securities must make price a primary focus.
The effect of financial distress on business results. Take into account any income statement and cash flow distortions caused by the Chapter 11 process itself.
Likely restructuring alternatives, including a detailed understanding of the different classes of securities and financial claims outstanding and who owns them.
An understanding of the reorganization process in general as well as the specifics of the situation being analyzed.
Understand the corporate balance sheet:
- Value the assets of the debtor. Divide the assets into two parts.
  - The assets of the ongoing business
  - The assets available for distribution to creditors upon reorganization, such as excess cash, assets held for sale, and investment securities.
- Understand the liabilities.
Understanding off-balance-sheet assets, like real estate carried below current value, an overfunded pension plan, and patents owned.

Companies get into financial trouble for at least one of three reasons:

Operating problems
Legal problems
Financial problems

Financially distressed companies can try to survive outside bankruptcy by:

Resorting to cost-cutting
Selling assets
Getting an infusion of outside capital

The bankruptcy process can sometimes serve as a salutary catharsis, allowing troubled firms the opportunity to improve their business operations.
Bankrupt companies tend to build up substantial cash balances.

Three stages of bankruptcy:

The first stage, immediately after the Chapter 11 filing, is the time of greatest uncertainty but perhaps also of greatest opportunity for investors
The second stage involves the negotiation of a plan of reorganisation and begins anywhere from a few months to several years after filing.
The final stage occurs between the finalization of a reorganisation plan and the debtor’s emergence from bankruptcy.

The Cycle of Investment Fads

When an investment area becomes popular, more money flows to specialists in the area.
The increased buying bids up prices, increasing the short-term returns of investors and to some extent creating a self-fulfilling prophecy.
This attracts still more investors, bidding prices up further.
While the influx of funds helps to generate strong investment results for the earliest investors, the resultant higher prices serve to reduce future returns.
The good investment performance, which was generated largely by those who participated in the area before it became popular, ends and a period of mediocre or poor results ensues.
Eventually, much of the “hot money” leaves the area.
This allows the smaller number of remaining investors to exploit existing opportunities as well as the newly created bargains resulting from forced selling.
The stage is set for another up-cycle.

How To Evaluate Stockbrokers And Money Managers

Personal ethics
Fair treatment of clients
Likelihood of achieving good investment results
The investment philosophy of the manager
Were past successes due to luck or skill?
Personal compatibility with the manager

Evaluating their investment results:

Was the record the result of one or two spectacular successes or of numerous moderate winners?
If this manager’s record turns mediocre after one or two spectacular successes are excluded, is there a sound reason to expect more home runs in the future?

Is this manager still following the same strategy that was employed to achieve his or her past successes?