Notes To The Book “Margin Of Safety”

Author: Seth Klarman

1991

Prepared by: Ronald R. Redfield, CPA, PFS

According to www.wikipedia.com Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor” is a name of a book written by SethKlarman, a successful value investor and President of the Baupost Group, an investment firm in Boston. This book is no longer published and sometimes can be found on eBay for more than $1000 (some consider it a collectible item).

These notes are hardly all encompassing. These are notes I would find helpful for me, as a money manager. I do not mention Klarman’s important premise of looking at investments as “fractional ownerships.” I don’t mention things like that in these notes, as I am already tuned into those concepts, and do not need a reminder. Hence a reader of these notes, should read the book on their own, and get their own information from it. I found this book at several libraries. One awsome library I went to was the New York Public Library for Science, Business and Industry.http://www.nypl.org/research/sibl/index.html

Throughout this paper you will see items in “quote marks.” The quotes exclusively represent direct quotes of Seth Klarman, from the book.

As I read this book, and through completion, I felt fortunate that I have been following most of his philosophies for many years. I am not comparing myself to Klarman, not at all. How could I ever compare myself to the greats of Klarman, Buffett, Whitman etal? What I did experience via this reading was a confirmation of my style and discipline. This book really put together and confirmed to me, so many of the philosophies and methods which I have been using for many years. These notes are a means for me to

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look back, and feel my roots every so often. At times in these notes, I have added sections which I have found appropriate in my workings.

Introduction

“This book alone will not turn anyone into a successful value investor. Value investing requires a great deal of hard work, unusually strict discipline and a long-term investment horizon.”

“This book is a blueprint that, if carefully followed, offers a good possibility of investment successes with limited risk.”

Understand why things work. Memorizing formulas give the appearance of competence. Klarman describes the book as one about “thinking about investing.”

I interpret much of the introduction of the book, as to not actively buy and sell investments, but to demonstrate an “ability to make long-term investment decisions based on business fundamentals.” As I completed the book, I realize that Klarman does not embrace the long term approach in the same fashion I do. Yet, the key is to always determine if value still exists. Value is factored in with tax costs and other costs.

Fight the crowd. I think what Klarman is saying is that it is warm and fuzzy in the middle of crowds. You do not need to be warm and fuzzy with investing.

Stay unemotional in business and investing!

Study the behavior of investors and speculators. Their actions “often inadvertently result in the creation of opportunities for value investors.”

“The most beneficial time to be a value investor is when the market is falling.” “Value investors invest with a margin of safety that protects from large losses in declining markets.” I have only begun the book, but am

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curious as to how any value investor could have stayed out of the way of 1973 –1974 bear market. Some would argue that Buffett exited the business during this period. Yet, it is my understanding, and I could be wrong, that Berkshire shares took a big drop in that period. Also, Buffett referred his investors who were leaving the partnership to Sequoia Fund. Sequoia Fund is a long term value investment mutual fund. They also had a horrendous time during the 1973 –1974 massacre.

“Mark Twain said that there are two times in a man’s life when he should not speculate: when he can’t afford it and when he can.”

“Investors in a stock expect to profit in at least one of three possible ways:

a.From free cash flow generated by the underlying business, which will eventually be reflected in a higher share price or distributed as dividends.

b.From an increase in the multiple that investors are willing to pay for the underlying business as reflected in a higher share price.

c.Or by narrowing of the gap between share price and underlying business value.”

“Speculators are obsessed with predicting – guessing the direction of prices.”

“Value investors pay attention to financial reality in making their investment decisions.”

He discusses what could happen if investors lost favor with liquid treasuries, and if indeed they became illiquid. All investors could run for the door at once.

“Investing is serious business, not entertainment.”

Understand the difference between an investment and a collectible. An investment is one, which will eventually be able to produce cash flow.

“Successful investors tend to be unemotional, allowing the greed 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.”

He discusses Mr. Market. He mentions when a price of a stock declines with no apparent reason, most investors become concerned. They worry that there is information out there, which they are not privy to. Heck, I am going through this now with a position that is thinly traded, and sometimes I think I am the only purchaser out there. He describes how the investor begins to second-guess him or herself. He mentions it is easy to panic and just sell. He goes onto to write, “Yet, if the security were truly a bargain when it was purchased, the rationale course of action would be to take advantage of this even better bargain and buy more.”

Don’t confuse the company’s performance in the stock market with the real performance of the underlying business.

“Think for yourself and don’t let the market direct you.”

“Security prices sometimes fluctuate, not based on any apparent changes in reality, but on changes in investor perception.” This could be helpful in my research of the 1973 – 1974 period. As I study that era, it looks as though price earnings ratios contracted for no real apparent reason. Many think that the price of oil and interest rates sky rocketed, but according to my research, that was not until later in the decade.

He discusses the good and bad of Wall Street. He identifies how Wall Street is slanted towards the bullish side. The reason being that bullishness generates fees via offerings, 401k’s, floating of debt, etc. etc. One of the sections is titled, “Financial Market Innovations Are Good for Wall Street But Bad for Clients.” As I read this, I

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