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.

marginofsafetyMargin 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.”


Guru Speak: A glimpse into John Maynard Keynes’ profoundness

sepia tone if possA predominant economist from the early 20th century credited with shaping modern economic theory, now called ‘Keynesian theory’, John Maynard Keynes was a British economist and thinker who wrote a number of influential books and essays such as ‘The Economic Consequences of the Peace’, ‘The End of Laissez-faire’ and ‘The General Theory of Employment, Interest and Money’. His writings, though centered around economics, gradually covered issues around human behavior, his profession and philosophy, and often had far-reaching, profound impact.

Here is a selection of a few lines from his famous writings:

1. When the accumulation of wealth is no longer of high social importance, there will be great changes in the code of morals.

2. By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens.

3. The long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task, if in tempestuous seasons they can only tell us that when the storm is past, the ocean will be flat again.

4. Most men love money and security more, and creation and construction less, as they get older.

5. Education is the inculcation of the incomprehensible, into the indifferent, by the incompetent.

6. If you owe your bank a hundred pounds, you have a problem. But if you owe it a million, the bank has.

7. The power to become habituated to his surroundings is a marked characteristic of mankind.

8. For my part I think that capitalism, wisely managed, can probably be made more efficient for attaining economic ends than any alternative system yet in sight, but that, in itself, it is in many ways extremely objectionable.

9. Capitalism is the astonishing belief that the nastiest motives of the nastiest men somehow or other work for the best results in the best of all possible worlds.

10. I do not know which makes a man more conservative — to know nothing but the present, or nothing but the past.

11. The difficulty lies, not so much in developing the new ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds.

12. Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole.

13. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.

14. It is generally agreed that casinos should, in the public interest, be inaccessible and expensive. And perhaps the same is true of Stock Exchanges.

15. For the importance of money essentially flows from its being a link between the present and the future.

16. People are apt to be unduly interested in discovering what average opinion believes the average opinion to be; and this weakness finds its nemesis in the stock market.

17. Markets can remain irrational longer than you can remain solvent.

18. If farming were to be organized like the stock market, a farmer would sell his farm in the morning when it was raining, only to buy it back in the afternoon when the sun came out.

19. Most, probably all, of our decisions to do something positive, the full consequences of which will be drawn out over many days or years to come, can only be taken as the result of animal spirits—a spontaneous urge to action rather than inaction, and not as much the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.

20. It is better to be roughly right than precisely wrong.

Book Synopsis: The Black Swan by Nassim Nicholas Taleb

The_Black_SwanI recently finished reading ‘The Black Swan: The Impact of the Highly Improbable’ by Nassim Nicholas Taleb, the Lebanese essayist, writer, philosopher.

I had read his ‘Fooled by Randomness’ a few years back, and the essential message of this book is, more or less, similar. The basic premise of both the books is this: The past is always only clear in hindsight, and it is not a good predictor of the future. The additional elaboration in this book (and a lot of it!) is that not only is the past random, but the future is not predictable based on the past simply because, most of the times, the future happens due to a ‘Black Swan’ event that nobody can predict in advance, but ends up shaping the future.

While this is the core concept, the book is relentless in providing multiple examples through history, culture and markets to prove the point. While the book is not in the same category as some of the legendary ‘Guru Books’, it is still reasonably decent reading with some good takeaways once you get this basic point of the futility of predicting the future. It tends to get a bit self obsessed at times, and keeps on rambling in a sense – often forcing the reader to, kind of, turn to the next page after getting the point. One of the disappointments of the book is that eventually it ends without any clear thoughts on how to handle ‘black swan’ events, except saying that ‘get it into your mindset and prepare for it’.

Now, whether one agrees or not with the basic proposition based on which this book is written, it contains a number of nice quotes that make you stop and wonder whether it is humor or wisdom or both. So if one can have the patience to finish the book, it does contain a number of such snippets which provide for entertaining reading.

Here are a few of those excerpts from ‘The Black Swan’ that are worth remembering:

1. ‘Black swans’ are highly consequential but unlikely events that are easily explainable – but only in retrospect. Black swans have shaped the history of technology, science, business and culture. As the world gets more connected, black swans are becoming more consequential.

2. When you develop your opinions on the basis of weak evidence, you will have difficulty interpreting subsequent information that contradicts these opinions, even if this new information is obviously more accurate.

3. If you hear a “prominent” economist using the word ‘equilibrium,’ or ‘normal distribution,’ do not argue with him; just ignore him, or try to put a rat down his shirt.

4. In developing treatment theories, doctors most commonly get mixed up between absence of evidence and evidence of absence. So do statisticians.

5. The inability to predict outliers implies the inability to predict the course of history.

6. If the past, by bringing surprises, did not resemble the past previous to it (what I call the past’s past), then why should our future resemble our current past?

7. Things always become obvious after the fact.

8. Missing a train is only painful if you run after it! Likewise, not matching the idea of success others expect from you is only painful if that’s what you are seeking.

9. Cumulative errors depend largely on the big surprises, the big opportunities. Not only do economic, financial, and political predictors miss them, but they are quite ashamed to say anything outlandish to their clients — and yet events, it turns out, are almost always outlandish.

10. The same past data can confirm a theory and its exact opposite! If you survive until tomorrow, it could mean that either a) you are more likely to be immortal or b) that you are closer to death.

And finally, the book ends with this.

“I am sometimes taken aback by how people can have a miserable day or get angry because they feel cheated by a bad meal, cold coffee, a social rebuff, or a rude reception… We are quick to forget that just being alive is an extraordinary piece of good luck, a remote event, a chance occurrence of monstrous proportions.”

“Imagine a speck of dust next to a planet a billion times the size of the earth. The speck of dust represents the odds in favor of your being born; the huge planet would be the odds against it. Don’t be like the ingrate who got a castle as a present and worried about the mildew in the bathroom… remember that you are a Black Swan.”

Book Synopsis: The Difficulty of Being Good by Gurcharan Das

the-difficulty-ofbeinggood“What is here is found elsewhere. What is not here is nowhere.” – Mahabharata

With these words from the epic, Gurcharan Das starts the prelude to his book “The Difficulty of Being Good”, which I had the opportunity to read over the past few days. An output from what he terms as his ‘academic holiday’, this fairly scholarly piece of work by the former CEO of Procter and Gamble and columnist, is a thorough and in-depth examination into the main characters in the Mahabharata, their stories and their moral dilemmas, their relevance and application in today’s day and age, a search for the meaning of dharma, and the eventual conclusion that ‘Dharma is Subtle’.

The book is fairly heavy reading even for regular readers of non-fiction, but is worth the effort. It has loads of wisdom on every page, and content that will take time for even the most patient readers to absorb. Not exactly following the story line of the Mahabharata, the book takes one character at a time and analyzes the major events that happen with the character, and then tries to answer the age-old question “What is dharma?” In the process, it provides the reader a wonderful insight into the human traits of the key characters.

The author argues that while envy drives Duryodhana and he is largely an ‘evil’ character; for someone who is convinced that the throne belongs to him and whose goal is to win, Duryodhana’s singular drive and endless discontent may be something that one can learn from.

In his analysis of the ‘pravritti-oriented’ Draupadi and her courage, there are some really interesting insights from her conversations with the ‘nivritti-oriented’ Yudhishthira on ‘Why be Good?’ and the various explanations for it. A significant part of the book also focuses on the ‘un-hero’ Yudhishthira and his search for ‘dharma’, and how he undergoes a transformation from being a passive, non-violent, strictly moral prince to a more pragmatic, active and balanced righteous king, on realising the inherent conflicts between being a ruler and being good.

While noting that Bheeshma is perhaps the most ideal character in the Mahabharata and that his striking trait is selflessness, the author also questions whether selflessness is always good, especially if, like in Bheeshma’s case, it actually led to the Mahabharata. If his pledge were not taken, perhaps things would have been smooth with Bheeshma taking the throne.

The author also goes on to explain the status anxiety faced by Karna, its relevance in today’s society, and why he is the ‘most lamented’ character in the epic; as well as the despair faced by Arjuna when he refused to take arms. The author finally takes a detailed look at Krishna and his guile and how it was singularly responsible for the Pandava victory, specially due to its use in the death of all the Kaurava commanders-in-chief – namely Bheeshma, Drona, Karna and Duryodhana. He analyses the character of Krishna both as a human and as God, and eventually concludes that the only justification for his actions is that He is God.

All through the book the author constantly provides contemporary parallels to the epic’s events, and tries to answer the question on whether it is possible to be good and still achieve your goals, and why it is so difficult. These examples range from personal dilemmas in day to day life, positions that corporates and administrators are likely to find themselves in, decisions regarding law and policy makers as well as international issues.

Eventually the conclusion is a highly profound piece of writing some of which I quote below:

“Good behaviour is not rewarded generously in the epic; the virtuous suffer banishment and deprivation, while the wicked flourish in their palaces. Nor does the epic seem to explain why ‘good’ persons, who had a strong and persuasive case to make war, could win only by unfair means? And if so, how can we still call them ‘good’? It has told us that dharma is hidden in a cave, but even if it is found, it is so subtle that it slips from our grasp.”

“There is no single definition of dharma, it is matter of a fine balance  and dharma is subtle. Dharma is supposed to uphold a certain cosmic balance and it is expected to help us balance the plural ends of life – desire, material well being and righteousness – when they come into conflict. However, dharma does not do a very good job at it.”

Overall, a wonderful read, if one has the inclination and patience to absorb it.

Two Books: The Lazy Person’s Guide and The Coffeehouse Investor

I had the opportunity to read two books over the past two weeks.

the-lazy-persons-guide-to-investingThe First One was ‘The Lazy Person’s Guide to Investing’ by Dr Paul Ferrell, a former investment banker with Morgan Stanley and a columnist later, with some really useful and simple advice for the individual investor.

Here are some excerpts:

“Investing really is very simple stuff. You can do it yourself.”

“Lazy portfolios are keep-it-simple, no-hassle, low-stress, time-saving, low-maintenance portfolios–so you can get on with the business of everyday life.”

“Believing that investing requires some kind of special or weird thinking that you don’t have will blind you to your own natural instincts.”

“The only solution is to be in the market all the time and stop jumping in and out.”

“The more I know, the more I know I just don’t know, and neither does anyone else.”

“Taxes, Time, and Psychology favor the laziest portfolios.”

“The market is totally random, irrational, and unpredictable. And it loves humbling the mighty. Try to beat it and you’ll lose money.”

“Perhaps the single most important lesson you’ll need on the road to becoming a millionaire is frugality.”

“A penny saved is a dollar earned, thanks to compounding.”

“Buy the whole market with index funds, and never sell.”

“Experience has taught me that the relentless noise from breaking news sources, like CNN and CNBC, easily distracts most investors from what really works in the long run.”

“The ideal hybrid fund acts like a whole portfolio, diversifying between stocks and bonds for you.”

“Keep it simple, very simple. Lazy investing works.”

thecoffeehouseinvestorAnd the other book was ‘The Coffeehouse Investor’ by Bill Schultheis, a former broker with Solomon Smith Barney.

Here are some excerpts from it:

“The first step in being a responsible investor is to calculate an approximate savings goal.”

“We have the misconception that dealing with something so far away means sorting through thousands of mutual funds, hundreds of advisors and dozens of financial magazines.”

“The three fundamental principles of investing: Asset allocation; approximating the stock market average; saving–and these three principles are in our control.”

“As long as Wall Street has a vested interest in lots of transactions and busy portfolios, investors will continue to latch on to the hype and hysteria of Wall Street, perpetuating the misconception that by carefully reviewing market trends, diligently studying mutual fund tables, religiously researching global economies and closely watching interest rates, anyone and everyone can own a successful portfolio.”

“Let go of the mistaken belief that the secret to a successful portfolio is to accurately forecast bull and bear markets.”

“I know of no other industry in which so many self-proclaimed experts try so hard to convince us that they are wildly successful at that which they so miserably fail.”

“The most important factor when diversifying is to adhere to your asset allocation strategy, because when you stick to your strategy and rebalance your asset at year-end, buy and sell decisions are no longer arbitrary.”

“Maybe if mutual fund companies sent a bill each month, more investors would take the time to see whether they were getting their money’s worth.”

“Somewhere along the line Wall Street has forgotten that we can retire and be happy on a little less than millions and millions of dollars.”

“Strike a balance.–It is not worth making our life miserable today so you can retire in style tomorrow.”

“When we simplify investing, we take another step toward discovering our contagious spirit and our unique energy in such a way that we impact our world, making this a better place for everyone. I suspect that’s what most of us would say life’s all about.”

Some wonderful, honest and wise words indeed!

Guru Speak: An Uncommon Man, Philip Fisher’s Famous Words

philfisherPhilip Fisher was an American investor best known as the pioneer of growth investing and the author of Common Stocks and Uncommon Profits, a guide to growth investing that has remained in print ever since it was first published in 1958.

1. There is a complicating factor that makes the handling of investment mistakes more difficult. This is the ego in each of us. None of us likes to admit to himself that he has been wrong. If we have made a mistake in buying a stock but can sell the stock at a small profit, we have somehow lost any sense of having been foolish.

2. On the other hand, if we sell at a small loss we are quite unhappy about the whole matter. This reaction, while completely natural and normal, is probably one of the most dangerous in which we can indulge ourselves in the entire investment process.

3. More money has probably been lost by investors holding a stock they really did not want until they could ‘at least come out even’ than from any other single reason. If to these actual losses are added the profits that might have been made through the proper reinvestment of these funds if such reinvestment had been made when the mistake was first realized, the cost of self-indulgence becomes truly tremendous.”

4. Investment is rarely an optimized process in hindsight. Most of the time, you can attempt to position yourself for a sub-optimal return, which ain’t too bad at all.

5. I don’t want a lot of good investments; I want a few outstanding ones. If the job has been correctly done when a common stock is purchased, the time to sell it is almost never.

6. I remember my sense of shock some half-dozen years ago when I read a [stock] recommendation to sell shares of a company . . . The recommendation was not based on any long-term fundamentals. Rather, it was that over the next six months the funds could be employed more profitably elsewhere.

7. The stock market is filled with individuals who know the price of everything, but the value of nothing.

The Talent Myth: What ‘Outliers’ and ‘Talent is Overrated’ found about Success

Sehwag already held the record for the highest Test score of 319 by an Indian. Now he also holds the record for the highest ODI score of 219 by an Indian and by any cricketer.

That’s not bad going, especially for someone who started his career with a game in which he scored 1 and conceded 35 runs in 3 overs, and then was not picked for 20 months. Till he was promoted to open the innings seemingly by chance only because Sachin Tendulkar was injured. The success that Sehwag achieved after that is attributed, to a large extent, to his ‘innate hand-eye coordination talent’.

In the case of the legendary Sachin, people always talk of his exceptional talent from a young age which is apparently responsible for his success. Federer’s greatness was due to ‘exceptional talent and grace’.  Tiger Woods was always ‘a prodigy who was a gift to golf.’

We love talking about talent. And look for it in our achievers of the past and the present; as well as search for it in our children for the future. Even in fields other than sport, where people achieve success, it is attributed to talent. Therefore, apparently, Warren Buffett was ‘a born investor with a talent for spotting opportunities’, Bill Gates was ‘a child prodigy born to be a geek’, Mozart was ‘brilliance from the age of 5’. Even in business, Steve Jobs was  ‘a blessed engineer with the heart of an artist.’

I have often felt that while it may make good inspirational story telling, this is far from the truth. At some level, it is also an insult to the efforts put in by these individuals, and turns a blind eye to the role played by chance. If these individuals are asked the reasons for their success, I would be really surprised if even one of them said, “Well, I was born with the talent for this – so all I had to do was to go there and decide to be whatever I became.”

outliersI recently read a couple of books which completely debunk this theory of talent being the reason for success – either of the superlative kind, or even the reasonably common but consistent success. And I am reasonably convinced that, that is true.

The first one titled “Outliers: The Story of Success” by Malcolm Gladwell, through a lot of examples, highlights the “10,000-Hour Rule”, claiming that the key to superlative, outlier success in any field is, to a large extent, a matter of practicing a specific task or set of tasks for a total of around 10,000 hours. And the closer one gets to the 10,000 hours, the closer is one likely to get to what ‘looks like genius.’

TalentIsOverratedThe second one titled “Talent is Overrated” by Geoff Colvin gets a bit more specific and refines it further. It says that the best people in any field are those who devote the most hours to what is called “deliberate practice.” It means activities that are explicitly intended to improve performance, that reach for objectives just a bit beyond one’s current level of competence, provides feedback on results and involves high levels of repetition.

So the good news is that talent is not the reason for success, so forget the notion of being ‘gifted’ for being successful. The bad news is that it will still require a lot of hard work, and it is highly likely that chance smiles on you in that process of work. As a famous man said, “The harder I work, the luckier I get.”

For most people, work is hard enough even without pushing harder – without coming anywhere close to the ‘10,000 hours’ or to the ‘repetitive deliberate practice’. Those extra steps are so much harder that they almost never get done. And hence, great performance is hard and rare, not due to some innate gift.

But why do some people push themselves? The answer to that ‘why’ is not that simple – it is an existential one, a combination of individual motivation and commitment to whatever their area of work. It is likely to be made up of simple, normal reasons in most cases, at least during the initial phases. But beyond a particular point, it is a bit like what the famous mountaineer George Mallory’s response. When asked why he wants to climb Mount Everest, he said, “Because it is there.”

So try explaining the 319, 219 and may be many more such scores by Sehwag. Or the 100 hundreds of Sachin. Or a great achievement in any sphere of work. Talent is not the reason. At best, it may only be a starting point. The myth of talent being the reason needs to give way to the reality of hard work, the role of chance and the individual’s commitment. As Po learnt in Kung Fu Panda, “There is no secret ingredient. It’s just you.”

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