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30 Big Ideas from Seth Klarman’s Margin of Safety
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Foreword
With the possible exception of Warren Buffett, no investor today commands more respect than Baupost Group’s Seth Klarman. Since founding his investment partnership in 1983, Klarman has not only produced unrivaled returns (in excess of 20% per year), but he has also from time to time offered wise and timeless commentary on markets and the craft of investing.
He is the author of Margin of Safety, Risk Averse Investing Strategies for the Thoughtful Investor, which became a value investing classic ever since it was first published in 1991.
As I was reading Margin of Safety for the third time, I thought of collating the key ideas Klarman has written about, and present to you as a compilation. These ideas are hardly all encompassing of the wisdom Klarman distills through this amazing book, but these have helped me as an investor over the years. This book was written more than 20 years ago, yet Klarman’s ideas are perfectly suitable today.
All ideas in this Special Report represent direct quotes of Klarman from Margin of Safety. I have not tried to interpret them for the simple reason that I couldn’t have said better what Klarman says through these thoughts.
Here are 30 big ideas that Klarman presents through Margin of Safety, which I believe can help you become a more sensible and simpler investor.
#1: Value Investing isn’t Easy
Value investing requires a great deal of hard work, unusually strict discipline, and a long-term investment horizon. Few are willing and able to devote sufficient time and effort to become value investors, and only a fraction of those have the proper mindset to succeed.
Like most eighth-grade algebra students, some investors memorize a few formulas or rules and superficially appear competent but do not really understand what they are doing. To achieve long-term success over many financial market and economic cycles, observing a few rules is not enough.
Too many things change too quickly in the investment world for that approach to succeed. It is necessary instead to understand the rationale behind the rules in order to appreciate why they work when they do and don't when they don't. Value investing is not a concept that can be learned and applied gradually over time. It is either absorbed and adopted at once, or it is never truly learned.
Value investing is simple to understand but difficult to implement. Value investors are not super-sophisticated analytical wizards who create and apply intricate computer models to find attractive opportunities or assess underlying value.
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.
#2: Being a Value Investor
The disciplined pursuit of bargains makes value investing very much a risk-averse approach. The greatest challenge for value investors is maintaining the required discipline.
Being a value investor usually means standing apart from the crowd, challenging conventional wisdom, and opposing the prevailing investment winds. It can be a very lonely undertaking.
A value investor may experience poor, even horrendous, performance compared with that of other investors or the market as a whole during prolonged periods of market overvaluation. Yet over the long run the value approach works so successfully that few, if any, advocates of the philosophy ever abandon it.
#3: An Investor’s Worst Enemy
If investors could predict the future direction of the market, they would certainly not choose to be value investors all the time. Indeed, when securities prices are steadily increasing, a value approach is usually a handicap; out-of-favor securities tend to rise less than the public's favorites. When the market becomes fully valued on its way to being overvalued, value investors again fare poorly because they sell too soon.
The most beneficial time to be a value investor is when the market is falling. This is when downside risk matters and when investors who worried only about what could go right suffer the consequences of undue optimism. Value investors invest with a margin of safety that protects them from large losses in declining markets.
Those who can predict the future should participate fully, indeed on margin using borrowed money, when the market is about to rise and get out of the market before it declines. Unfortunately, many more investors claim the ability to foresee the market's direction than actually possess that ability. (I myself have not met a single one.)
Those of us who know that we cannot accurately forecast security prices are well advised to consider value investing, a safe and successful strategy in all investment environments.
#4: It’s All about the Mindset
Investment success requires an appropriate mindset.
Investing is serious business, not entertainment. If you participate in the financial markets at all, it is crucial to do so as an investor, not as a speculator, and to be certain that you understand the difference.
Needless to say, investors are able to distinguish Pepsico from Picasso and understand the difference between an investment and a collectible.
When your hard-earned savings and future financial security are at stake, the cost of not distinguishing is unacceptably high.
#5: Don’t Seek Mr. Market’s Advice
Some investors – really speculators – mistakenly look to Mr. Market for investment guidance.
They observe him setting a lower price for a security and, unmindful of his irrationality, rush to sell their holdings, ignoring their own assessment of underlying value. Other times they see him raising prices and, trusting his lead, buy in at the higher figure as if he knew more than they.
The reality is that 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.
Emotional investors and speculators inevitably lose money; investors who take advantage of Mr. Market's periodic irrationality, by contrast, have a good chance of enjoying long-term success.
#6: Stock Price Vs Business Reality
Louis Lowenstein has warned us not to confuse the real success of an investment with its mirror of success in the stock market.
The fact that a stock price rises does not ensure that the underlying business is doing well or that the price increase is justified by a corresponding increase in underlying value. Likewise, a price fall in and of itself does not necessarily reflect adverse business developments or value deterioration.
It is vitally important for investors to distinguish stock price fluctuations from underlying business reality. If the general tendency is for buying to beget more buying and selling to precipitate more selling, investors must fight the tendency to capitulate to market forces.
You cannot ignore the market – ignoring a source of investment opportunities would obviously be a mistake but you must think for yourself and not allow the market to direct you.
#7: Price Vs Value
Value in relation to price, not price alone, must determine your investment decisions.
If you look to Mr. Market as a creator of investment opportunities (where price departs from underlying value), you have the makings of a value investor.
If you insist on looking to Mr. Market for investment guidance, however, you are probably best advised to hire someone else to manage your money.
Because security prices can change for any number of reasons and because it is impossible to know what expectations are reflected in any given price level, investors must look beyond security prices to underlying business value, always comparing the two as part of the investment process.
#8: Emotions Play Havoc in Investing
Unsuccessful investors are dominated by emotion. Rather than responding coolly and rationally to market fluctuations, they respond emotionally with greed and fear.
We all know people who act responsibly and deliberately most of the time but go berserk when investing money. It may take them many months, even years, of hard work and disciplined saving to accumulate the money but only a few minutes to invest it.
The same people would read several consumer publications and visit numerous stores before purchasing a stereo or camera yet spend little or no time investigating the stock they just heard about from a friend.
Rationality that is applied to the purchase of electronic or photographic equipment is absent when it comes to investing.
#9: Stock Market ≠ Quick Money
Many unsuccessful investors regard the stock market as a way to make money without working rather than as a way to invest capital in order to earn a decent return.
Anyone would enjoy a quick and easy profit, and the prospect of an effortless gain incites greed in investors. Greed leads many investors to seek shortcuts to investment success.
Rather than allowing returns to compound over time, they attempt to turn quick profits by acting on hot tips. They do not stop to consider how the tipster could possibly be in possession of valuable information that is not illegally obtained or why, if it is so valuable, it is being made available to them.
Greed also manifests itself as undue optimism or, more subtly, as complacency in the face of bad news.
Finally greed can cause investors to shift their focus away from the achievement of long-term investment goals in favor of short-term speculation.
#10: Stock Market Cycles
All market fads come to an end. Security prices eventually become too high, supply catches up with and then exceeds demand, the top is reached, and the downward slide ensues.
There will always be cycles of investment fashion and just as surely investors who are susceptible to them.
It is only fair to note that it is not easy to distinguish an investment fad from a real business trend. Indeed, many investment fads originate in real business trends, which deserve to be reflected in stock prices.
The fad becomes dangerous, however, when share prices reach levels that are not supported by the conservatively appraised values of the underlying businesses.
#11: How Big Investors Misbehave and Why They Underperform
If the behavior of institutional investors weren't so horrifying, it might actually be humorous.
Hundreds of billions of other people's hard-earned dollars are routinely whipped from investment to investment based on little or no in-depth 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.
Indeed, the short-term, relative-performance orientation of many money managers has made "institutional investor" a contradiction in terms.
Most money managers are compensated, not according to the results they achieve, but as a percentage of the total assets under management. The incentive is to expand managed assets in order to generate more fees. Yet while a money management business typically becomes more profitable as assets under management increase, good investment performance becomes increasingly difficult.
This conflict between the best interests of the money manager and that of the clients is typically resolved in the manager's favor.
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