Thursday, April 23, 2009

Margin of Safety by Seth Klarman

by Saj Karsan

In the next few weeks, we'll be doing a chapter-by-chapter run-down of Seth Klarman's sought after book, Margin Of Safety. We've discussed Klarman on my website before, as he has consistently demonstrated an ability to generate market beating returns over a long period of time. You can find Klarman's limited edition book selling on ebay for hundreds of dollars.

Chapter 1
Klarman starts out by distinguishing investing from speculating. He uses a Mark Twain quote to illustrate the two times in life when one shouldn't speculate: "when you can't afford it, and when you can!". Speculators buy in the hopes or assumptions that others will want to buy the same asset (be it a painting, a baseball card, or a stock) later, while investors buy the cash flow the investment returns to its owner. (As such, a painting can never be an investment by this definition!)

Chapter 2
What's good for Wall Street is not necessarily good for investors, according to Klarman. Because of how Wall Street does business, it has a very short-term focus. For example, Wall Street makes money up-front on commissions (not from long-term performance), therefore the Street will always push for churn and will always push "hot" investments.

Chapter 3
In this chapter, Klarman discusses how the investment world has changed over the last several decades, and how understanding these changes allows investors to earn superior returns. From 1950 to 1990, the institutional share of the market rose from 8% to 45%, and institutions comprise 75% of market trading volume. But the institutions are hampered by a short-term mindset, and Klarman attempts to explain why.

Chapter 4
In this chapter, Klarman examines the junk bond market in depth to illustrate how Wall Street can create investment fads, only to leave investors much poorer when the tide goes out.

Chapter 5
In the previous four chapters, Klarman focused on describing how investors go wrong. Chapter 5 is an introduction to the second part of the book, where Klarman describes the philosophy of value investing.

Chapter 6
This chapter is dedicated to describing the philosophy of value investing and why it works. The terms used to describe value investing don't require any accounting or finance background, making this an easy read for beginners looking to learn about value investing.

Chapter 7
Klarman introduces what he calls the three central elements to a value investing philosophy:

1) A "bottom-up" strategy
2) Absolute (as opposed to relative) performance
3) A risk averse approach

Chapter 8
Business value cannot be precisely determined, Klarman asserts. Not only do a number of assumptions go into a business valuation, but relevant macro and micro economic factors are constantly changing, making a precise valuation impossible.

Klarman discusses what he believes to be the only three ways to value a business. The first method involves finding the net present value by discounting future cash flows. The second method is Private Market Value. Finally, Klarman discusses liquidation value as a method of valuation.

Chapter 9
Sometimes, there are so many value investments available that the only constraint on the investor is a lack of funds. Most times, however, Klarman finds it difficult to find value investment opportunities. Investors can spend a lot of time reading through financial reports, research reports, and other financial news and end up finding nothing but fairly valued opportunities. Therefore, it is important that the investor look in the right places.

A few of the places Klarman suggests finding investment opportunities include the new-low lists and the largest percentage-decliners lists which are published by major news sources. Klarman also finds that companies whose dividends have been cut or eliminated can also be unduly punished by the market, leaving investment opportunities. Of course, just because a stock shows up on one of these lists does not make it a buy; one still has to go through the valuation process described in previous chapters in order to determine whether it trades at a discount to its fair value.

Chapter 10
This chapter contains of a plethora of value investing examples. Klarman details a number of securities where investors who paid attention to fundamentals (e.g. strong businesses masked by unprofitable divisions, or companies trading at discounts to cash etc.) reaped enormous profits.

Chapter 11
This chapter examines opportunities at the time of writing that value investors had in the banking sector. In the mid-1980s to early 1990s, many banks were selling for less than book value. During the recession of the early 90s, many thrifts had to be bailed out by the government due to some of the high-risk loans they had offered and due to the general downturn in the US real-estate market...remind you of today?

* * *

Value-Stock-Plus page

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[12/1/09] Currently, Seth Klarman is very popular in the value investment community. He is particularly popular on Gurufocus.com, where people are literally watching every move he makes.

One of the biggest mysteries about Klarman is what is he is actually holding in his portfolio. You can see his stock and convertible bond holdings and their value filed under the 13-F. In Baupost's 13-F for Q3, total securities listed are $1.36 billion dollars. Klarman stated that he had 30% of his portfolio in cash which is not listed on the 13-F.

Now, here is the shocking part. I called up Baupost and they informed me that they had slightly under $20 billion assets under management. Let us assume that they are managing about $18 billion because that is slightly under the amount they named. That means $6 billion is in cash and $1.36 billion is in stocks and convertible bonds. That leaves more than 50% of their assets or about $10.6 billion not listed in their 13-F.

This $1.36 billion is not an insignificant number, however it is clear that most of his return are coming not from the $6 billion in cash or even the $1.36 billion in stocks and convertibles. Most of his return is coming from his bond holdings. In fact, we would not even know that he had $6 billion had the notes not leaked out from the Baupost meeting. Without these details, all one would know is that Baupost had $1.3 billion in convertibles and stocks and about $17 billion unaccounted for.

One important thing to remember is when you see that Klarman has posted 20% returns annually, you might think you can achieve the same returns by coping him. However, this is not necessarily the case since most of his gains are coming from his bonds (which are not reported). This does not mean that Klarman is not an amazing stock investor or that his stock investments should be ignored. In fact, he has achieved some spectacular results from his stock portfolio, including a recent 75% return in one day from his holding in Facet Biotech Corporation. The significance of the above information is one must realize before trying to mimic Klarman is that you are only seeing a small fraction of the full picture. I doubt we will ever know what Klarman’s full holdings truly are.

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[9/12/10] Seth Klarman interviewed by Jason Zweig

[12/1/11] Seth Klarman interviewed by Charlie Rose (video)

[4/19/12] Notes to Margin of Safety

[4/28/13] The real secret to investing is that there is no secret to investing. Every important aspect of value investing has been made available to the public many times over, beginning with the rst edition of Security Analysis. That so many people fail to follow this timeless and almost foolproof approach enables those who adopt it to remain successful. The foibles of human nature that result in the mass pursuit of instant wealth and effortless gain seem certain to be with us forever. So long as people succumb to this aspect of their natures, value investing will remain, as it has been for 75 years, a sound and low risk approach to successful long term investing.

—Seth Klarman, The Baupost Group [from the Art of Value Investing]

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