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

1

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

2

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 was wondering if the “pay option mortgages,” which are being offered by many lenders, are one of these products. These negative amortization and adjustable mortgages have been around for 25 years. Yet, they have not proliferated the marketplace in the past as much as they have the last several years. Lenders such as Countrywide, GoldenWest Financial and First Federal Financial have been using these riskier mortgages as a typical type of loan in 2005 and 2006. “Investors must recognize that the early success of an innovation is not a reliable indicator of its ultimate merit.” “Although the benefits are apparent from the start, it takes longer for the problems to surface.” “What appears

4

to be new and improved today may prove to be flawed or even fallacious tomorrow.”

“The eventual market saturation of Wall Street fads coincides with a cooling of investor enthusiasm. When a particular sector is in vogue, success is a self-fulfilling prophecy. As buyers bid up prices, they help to justify their original enthusiasm. When prices peak and start to decline, however, the downward movement can also become self-fulfilling. Not only do buyers stop buying, they actually become sellers, aggravating the oversupply problem that marks the peak of every fad.”

He later writes about investment fads. “All market fads come to an end.” He clarifies, “It is only fair to note that it is not easy to distinguish an investment fad from a real business trend.”

“You probably would not choose to dine at a restaurant whose chef always ate elsewhere. You should be no more satisfied with a money manager who does not eat his or her own cooking.” Just to reiterate, I do eat my own cooking, and I don’t “dine out” when it comes to investing.

“An investor’s time is required both to monitor the current holdings and to investigate potential new investments. Since most money managers are always looking for additional assets to manage, however, they spend considerable time meeting with prospective clients in addition to handholding current clientele. It is ironic that all clients, Present and potential, would probably be financially better off if none of them spent time with money managers, but a free-rider problem exists in that each client feels justified in requesting periodic meetings. No single meeting places an intolerable burden on a money manager’s time; cumulatively, however, the hours diverted to marketing can take a toll on investment results.”

“The largest thrift owners of junk bonds – Columbia Savings and Loan, CenTrust Savings, Imperial Savings and Loan, Lincoln Savings and Loan and Far West Financial, were either insolvent of on the brink of insolvency by the end of 1990. Most of these institutions had grown rapidly through brokered deposits for the sole purpose of investing the proceeds in junk bonds and other risky assets.”

I personally suspect that the same will be said of the aggressive mortgage lenders of 2005 – 2006. I have looked back at my files of 1stquarter 1980 Value Line for a few of these companies mentioned above. Here are some notes on one of the companies I found.

Far West Financial: Rated C++ for financial strength. In 1979 it was selling for 5/% of book value. “The yield-cost spread is under pressure.” “Lending is likely to decline sharply in 1980.” “Far West’s earnings are likely to sink 30 – 35% in 1980. Reasons: The deteriorating margin between yield on earning assets and the cost of money, less loan fee income…” Keep in mind that the stock price rose around 400% from 1974 – 1979. From 1968 – 1972 the P/E ratio was in a range from 11 –17. From 1973 through 1979 the P/E ratio was in a range from 3.3 – 8.1. It would be interesting for me to look at the 1990 – 1992 Value Lines of the same companies.

A Value Investment Philosophy:

“One of the recurrent themes of this book is that the future is

“One of the recurrent themes of this book is that the future is unpredictable.” “The river may overflow its banks only once or twice in a century, but you still buy flood insurance.” “Investors must be prepared for any eventuality.” He describes that an investor looking for a specific return over time, does not make that goal achievable. “Targeting investment returns leads investors to focus on potential upside rather on downside risk.” “Rather than targeting a desired rate of return, even an eminently reasonable one, investors should target risk.”

Value Investing: The Importance of a Margin of Safety”

“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. The element of the bargain is the key to the process.”

Full article here Notes_To_Margin_of_Safety