Book Synopsis: Margin of Safety by Seth Klarman

Seth Klarman is the founder and president of The Baupost Group, a Boston-based private investment partnership. He wrote a book named ‘Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor’ which is an investment classic, but has been out of print since 1991. If you google for this book, you will find a scanned copy here.

For the individual investor, this is perhaps the best book you will ever read on investing, after The Intelligent Investor by Ben Graham.

Margin of Safety provides an excellent framework for value investing for the ‘enterprising’ investor referred by Graham. The entire philosophy of emphasizing risk over returns, and avoidance of loss as the cornerstone of any investing decision is over-arching in this book.

The book starts by providing reasons why most investors fail, how Wall Street (or Dalal Street or the financial industry) is not structured to work for the investor, as well as the Institutional constraints and performance race that they face which makes chasing market returns mandatory for them. Further, Klarman goes on to define the value investing philosophy based on the margin of safety as the foundation, the art of business valuation along with techniques for the same, as well as the process for finding value investments.

Here is a compilation of a set of excerpts from this book which are well worth reading and re-reading, and are reproduced below:

1. “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 mind-set to succeed.”
2. “Successful investors tend to be unemotional, allowing the greed and fear of others to play into their hands. By having confidence in their own analysis and judgment, they respond to market forces not with blind emotion but with calculated reason.”
3. “The problem is that what is good for Wall Street is not necessarily good for investors, and vice versa.”
4. “Most money managers are compensated, not according to the results they achieve, but as a percentage of the total assets under management. The pressure to retain clients exerts a stifling influence on institutional investors.”
5. “Like dogs chasing their own tails, most institutional investors have become locked into a short-term, relative-performance derby. Most institutional investors measure their success or failure in terms of relative performance. Money managers motivated to outperform an index or a peer group of managers may lose sight of whether their investments are attractive or even sensible in an absolute sense.”
6. “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.”
7. “Perseverance at even relatively modest rates of return is of the utmost importance in compounding your net worth. In other words, an investor is 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.”
8. “Rather than targeting a desired rate of return, even an eminently reasonable one, investors should target risk.”
9. “The avoidance of loss is the surest way to ensure a profitable outcome. Loss avoidance must be the cornerstone of your investment philosophy.”
10. “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.”
11. “It would be a serious mistake to think that all the facts that describe a particular investment are or could be known. Even if everything could be known about an investment, the complicating reality is that business values are not carved in stone. If you cannot be certain of value, after all, then how can you be certain that you are buying at a discount? The truth is that you cannot.”
12. “Because investing is as much an art as a science, investors need a margin of safety. A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility.”

Klarman describes three elements of a value investment philosophy: a bottoms-up approach to selecting investments one stock at a time, absolute performance orientation that enables one to buy and hold irrespective of short-term relative non-performance, and paying attention to real risk of capital loss not beta (volatility).

Klarman discusses the difficulty of the art of business valuation and recommends arriving at conservative but imprecise range of business value based on 3 or 4 techniques: Net Present Value of Free Cash Flows, Liquidation or Breakup value, and Stock Market Value – providing practical examples for various scenarios.

The last section of the book is more technical providing details of the three major areas of opportunity for value investment, namely catalysts, market inefficiencies and institutional constraints, as well as then going on to provide detailed evaluation methods for thrifts and bankruptcy situations. Eventually, Klarman goes on to provide insights into portfolio management as well as selection of a money manager for value investing.

Finally, Klarman ends his investment classic Margin of Safety with these lines: “I recommend that you adopt a value-investment philosophy and either find an investment professional with a record of value-investment success or commit the requisite time and attention to investing on your own.”