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"Margin of Safety", Seth Klarman


NEED to have discount to current value spreadsheet: OWN only the most undervalued. I am grateful to each of them (great buy and sell side folks) for teaching me so much about this business and for teaching me so much about this business… Ask questions and encouraged me to discover the answers… Many are not coherent investment programs but instead resemble speculation or outright gambling… I recommend one particular path for investors to follow- a value investment philosophy. Value investing, the strategy of investing in securities at an appreciable discount from underlying value… CONTINUOUS effort to maintain discipline (JL)… Pained by the disastrous investment results experienced by great numbers of unsophisticated, undisciplined investors (study your past)… Value investing requires a great deal of hard work, UNUSUALLY STRICT DISCIPLINE, and a long term investment horizon (yet sell decision mandatory when approaches value)… Book is a blueprint that offers a good possibility of investment success with limited risk)… Investors enmeshed in a short term relative performance derby (not for us). Relative performance oriented investors, already focused on short term returns, frequently are attracted to the latest market fads as a source of superior relative performance. The temptation of making a fast buck is great, and many investors find it difficult to fight the crowd…. When prices are generally rising, for example, greed leads investors to speculate, to make substantial, high risk bets based upon optimistic predictions, and to focus on return while ignoring risk. At the other end of the emotional spectrum, when prices are generally falling, fear of loss causes investors to focus solely on the possibility of continued price declines to the exclusion of investment fundamentals… Examine the behavior of other investors and speculators; their actions often inadvertently result in the creation of opportunities for value investors… Institutional behemoths bid up and trample (disregard value and treat as paper)… There is nothing esoteric about value investing. It is simply the process of determining the value underlying a security and then buying it at a conservable discount… THE GREATEST CHALLENGE IS MAINTAINING THE REQUISITE PATIENCE AND DISCIPLINE TO BUY ONLY WHEN PRICES ARE ATTRACTIVE AND SELL WHEN THEY ARE NOT… Primary goal is the preservation of capital. Seek a margin of safety, allowing room for imprecision, bad luck, or analytical error in order to avoid sizeable losses over time… The most beneficial time to be a value investor is when the market is falling… Value investing is either absorbed and adopted at once, or it is never truly learned… Finds value investing to be stimulating, intellectually challenging, ever changing, and financially rewarding discipline… Investors expect to profit in 3 possible ways: free cash flow generated, increase in multiple, narrowing of gap b/w share price and underlying value. Speculators buy based on if believe securities will rise or fall… Investments throw off cash flow for the benefit of the owners, speculations do not… Successful investors tend to be unemotional, allowing greed and fear of others to play into their hands… Demonstrate caution in frothy markets and steadfast conviction in panicky ones…. Sometimes Mr. Market sets price levels where you would neither want to buy nor sell. Frequently however, he becomes irrational. Sometimes he is optimistic and will pay far more than securities are worth. Other times he is pessimistic, offering to sell securities for considerably less than underlying value… (Bio-tech triple) Only explanation for the price rise was that investors were suddenly willing to pay much more than before to buy the same thing… Invest capital in order to earn a decent return… Greed also manifests itself as undue optimism or more subtly, as complacency in the face of bad news… High level of greed sometimes cause new-era thinking. Reasons are given as to why this time is different from anything that came before. Conservative assumptions are revisited and revised in order to justify ever higher prices… Finding bond yields unacceptably low, they (public) pour money into stocks at the worst imaginable times…. Buying low P/E’s is backward looking… It is crucial that investors understand the difference b/w speculating and investing and learn to take advantage of opportunities…


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… Home Shopping network reached $4.2b, a level considerably above that of most well-established department store chains… Will always be cycles of investment fashion and just as surely investors who are susceptible to them… Understanding institutional behavior is helpful in understanding why certain securities are overvalued while others are bargain priced and may enable investors to identify areas of potential opportunity… Investing at all times certainly simplifies the investment task. The investor simply chooses the best available investments. Relative attractiveness becomes the only yardstick; no absolute standard is to be met. Unfortunately, the important criterion of investment merit is obscured or lost when substandard investments are acquired solely to remain fully invested. Such investments will at best generate mediocre risk/adjusted returns; at worst they entail both a high opportunity cost- foregoing the next good opportunity to invest- and the risk of appreciable loss… There are times when the best thing to do is nothing at all… Allocating money into rigid categories simplifies investment decision making but only at the potential cost of lower returns… “in any sort of a contest- financial, mental or physical- it’s an enormous advantage to have opponents who have been taught that it’s useless to even try… Historically, many financial market innovations have gained widespread acceptance before being exposed as ill conceived… Most junk-bond buyers were probably unaware that they were implicitly assuming a great deal about the ongoing health of the economy and junk bond market. Issuers and investors alike assumed that cash flow would always grow and that upcoming maturities could be refinanced… Junk bond issuers, underwriters and investors each abandoned established standards of value for new, less rigorous criteria… Zero coupon and PIK debt, which accrue interest rather than paying it currently in cash, severed this tether of financial responsibility, permitting historically unprecedented multiples to be paid for businesses in the mid-late 1980’s… The rating agencies performed studies showing that the investment-grade rating was warranted. Predictably these studies used a historical default-rate analysis and neglected to consider the implications of either a prolonged economic downturn or a credit crunch that might virtually eliminate refinancing… Investors who study the junk-bond debacle may be able to identify these new fads for what they are and avoid them… As Buffett likes to say, “Don’t lose money”, and the second rule is, “Never forget the first rule.” This does not mean that investors should never incurs the risk of any loss at all (always some). Rather, “don’t lose money” means that over several years an investment portfolio should not be exposed to appreciable loss of principal... Today many people believe that risk comes, not from owning stocks, but from not owning them… The actual risk of a particular investment cannot be determined from historical data, it depends on the prices paid… If you are one of the vast majority of investors who are risk averse, then loss avoidance must be the cornerstone of your investment philosophy…The effects of compounding even moderate returns over many years are compelling… A corollary to the importance of compounding is that it is very difficult to recover from even one large loss (HAVE TO HEDGE downside of big position- bird flu)… An investor is more likely to do well by achieving consistently good returns with limited downside risk… An investor who earns 16% annual returns over a decade, will perhaps, surprisingly, end up with more money than an who earns 20% a year and the loses 15% the tenth year. The second investor will outperform, the former nine years out of ten, gaining considerable psychic income from this apparently superior performance… The prudent, farsighted investor manages his or her portfolio with the knowledge that financial catastrophes can and do occur. Investors must be aware that the world can change unexpectedly and sometimes drastically… Many investors must be aware that the world can change unexpectedly and sometimes dramatically… An investor cannot decide to think harder or put in overtime to achieve a higher return. All an investor can do is follow a consistently disciplined and rigorous approach. Targeting investment returns leads investors to focus on upside potential rather than on downside risk… 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… Sometimes a value investor will review in depth a great many potential investments without finding a single one that is sufficiently attractive. Such persistence is necessary however, since value is often well hidden… 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… Buffet: value investor is a batter in a game where no balls or strikes are called, allowing dozen, even hundreds, of pitches to go by, including many at which other batters would swing… They have INFINITE PATIENCE and are willing to wait until they are thrown a pitch they can handle- an undervalued investment opportunity… Few value investors will own the shares of technology companies. Many also shun commercial banks, which they consider to have unanalyzable assets… For a value investor, a pitch must not only be in the strike zone, it must be in his ‘sweet spot’. Results will be best when an investor is not pressured to invest prematurely… An investment must be purchased at a discount from underlying worth. A stock trading at one-half of its underlying value may be attractive, but another trading at one-fourth of its worth is better. Value investors continually compare potential new investments with their current holdings in order to ensure that they own ONLY THE MOST UNDERVALUED OPPORTUNITIES. In other words NO INVESTMENT SHOULD BE CONSIDERED SACRED WHEN A BETTER ONE COMES ALONG… When attractive opportunities are scarce, however, investors must exhibit great discipline in order to maintain the integrity of the valuation process and limit the price paid… ABOVE ALL, INVESTORS MUST ALWAYS AVOID SWINGING AT BAD PITCHES… Buying a dollar’s worth of assets for fifty cents may not be a bargain if the asset value is dropping. Historically, investors have found attractive opportunities in companies with substantial hidden assets… 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 in a complex, unpredictable and rapidly changing world… Some highly successful investors, including Buffet, have come increasingly to recognize the value of intangible assets- broadcast licenses or soft drink formulas, for example- which have a history of growing in value without any investment required to maintain them. Virtually all cash flow generated is free cash flow. The problem with intangible assets, I believe is that they hold little or no margin of safety. Tangible assets, by contrast, are more precisely valued and therefore provide investors with greater protection from loss. If consumer lose their taste for Dr. Pepper, tangible assets will not meaningfully cushion investors’ losses. How can investors be certain of achieving a margin of safety? By always buying at a significant discount to underlying business value. By replacing current holdings as better bargains come along. By SELLING when the MARKET PRICE OF ANY INVESTMENT COMES TO REFLICT ITS UNDERLYING VALUE AND BY HOLDING CASH… Look for investments with catalysts that may assist directly in the realization of underlying value. Give preference to companies having good managements with a personal financial stake in the business. Finally diversify your holdings and hedge when it is financially attractive to do so… Securities that have performed well in a strong market are usually those for which investors have had the highest expectations… Securities prices as if nothing could go right stand to benefit… Telefonos: focus on dilution and not book value, ignoring virtually every criterion of value… Buffet only thing that many value investors have in common is a philosophy that dictates the purchase of securities at a discount from underlying value…  A company that recently reported disappointing EPS might be dumped by investors who focused on earnings, depressing the price to a level considerably below underlying value… LOOK for SMALL-CAP SPINOFF (CRC)… The market is not a weighing machines, is a voting machines… In a sense, value investing is a large scale- arbitrage b/w security prices and underlying business value… Value pretenders are charlatans who violate the conservative dictates of value investing, using inflated business valuations, overpaying for securities, and failing to achieve a margin of safety for their clients (Steve Cohen understands the value of worse case and bull case and arbs that)… Value investors are not super sophisticated analytical wizards who create and apply intricate computer models to find attractive opportunities or asses underlying value. The hard part is discipline, patience and judgement. 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…1) identify specific undervalued investment opportunities 2) value investing is absolute performance; not relative performance oriented. Finally, value investing is a risk-averse approach; attention is paid to WHAT CAN GO WRONG (risk) as TO what can go right (return)… There is no margin of safety for top down investing; based on concept, theme or trend… Bottom up investors hold cash when they are unable to find attractive investment opportunities and put cash to work when opportunities appear. Only fully invested when a diversified portfolio of attractive investments is available… Bottom up able to identify what they are betting on: the uncertainties faced are limited; what is the underlying business worth, will that underlying value endure until shareholders benefit, what is the likelihood that the gap b/w price and value will narrow and given the current market price, what is the potential risk and reward… When the price appreciates to more fully reflect underlying business value, a DISCIPLINED INVESTOR can re-evaluate the investment and if appropriate sell it (spike on volume to reach prediction must sell at least ½)… HUGE SUMS HAVE BEEN LOST BY INVESTORS WHO HAVE BEEN LOST BY INVESTORS WHHO HAVE HELD ON TO SECURITIES AFTER THE REASON FOR OWNING THEM IS NO LONGER VALID (POST 70 in 2 years discounted at 10% is $56 only 10% away from full value)… Value investors are absolutely performance oriented. Good absolute performance is obtained by purchasing undervalued securities while selling holdings that become more fully valued… Some insist risk and return always positively correlated, not always true. In inefficient markets it is possible to find investments offering high returns with low risk. These arise when information is not widely available, when an investment is particularly complicated to analyze or when investors buy and sell for reasons UNRELATED TO VALUE… Greater risk does not guarantee greater return. To the contrary, risk erodes return by causing losses. Only few things an investor can do to counteract risk: diversify adequately, if not hedge when appropriate, and invest with a margin of safety (patience to wait for exhausted selling coupled with value)… Past price/volatility is a poor measure of risk… Possibility that interim price fluctuations are unrelated to value. Are temporary fluctuations really a risk? Not in a way that permanent value impairments are… If you are buying sound value at a discount do short term fluctuations matter? In the long run they do not matter much; value will ultimately be reflected in the price of a security… Price fluctuation matter to levered investors who may be forced to sell and levered companies who may have to source equity capital... If fully invested when the market declines, portfolio will likely drop in value, depriving you of the benefits arising from the opportunity to buy in at lower levels... Maintaining moderate cash balances or owning securities that periodically throw off appreciable cash balances (arb). Portfolio cash flow is greater for securities of shorter duration. Portfolio cash flow is also enhanced by investments with catalysts for the partial or complete realization of value (SEARCH TOOL IN BLOOMBERG)…  Bankruptcy and liquidation return appreciable cash in a couple years. Another way to limit opportunity cost is through hedging. The primary goal of value investors is to avoid losing MONEY (would have sold POST when near full value; KNDI spike, FNMA spike etc.). Search for low risk bargains and do not compare returns. An absolute performance orientation is consistent with loss avoidance; a relative performance valuation is not…10% 5 year bond goes to 5% can earn a 22% profit, if hold to maturity make 9.1% (reinvest coupons lower) while if goes to 15% immediately lose 17% to mark but if hold to maturity earning 10.99; short term and long-term perspectives on an investment can diverge… Man y investors seek precision in an imprecise world, but business value cannot be precisely determined… Not only is business value imprecisely knowable, it also changes over time, fluctuating with numerous macroeconomic, microeconomic, and market-related factors… The advent of the computerized spreadsheet has exacerbated this problem, creating the illusion of extensive and thoughtful analysis. Investors pay great attention to the output, and little to the assumptions… Businesses unlike debt, cannot be precisely valued… The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security, just that the value is considerably higher or lower than the market price. Must buy at a discount from intrinsic value. 1) The first is an analysis of going-concern value, known as net present value analysis. A frequently used but flawed shortcut method of valuing a going concern is known as private-market value. This is an investor’s assessment of the price that a sophisticated businessperson would be willing to pay for a business using multiples paid when comparable businesses were previously bought and sold in their entirety. 2) Liquidation value, the expected proceeds if dismantled and sold off 3) stock market value of company or subsidiaries would trade; less reliable than the other two, only occasionally useful as a yardstick of value…. Since entry to the ‘business hall of fame’ is frequently through a revolving door, investors may be lured into making overly optimistic projections based on temporarily robust results… A too high purchase price of the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments… Investors are well advised to make only conservative projections and then invest only at a substantial discount from the valuations derived therefrom… At times when interest rates are unusually low, however, investors are likely to fin very high multiples being applied to share prices. Investors who pay these high multiples are dependent on interest rates remaining low but no one can be certain that they will. This means that when interest rates are unusually low; investors should be particularly reluctant to commit capital to long term holdings unless outstanding opportunities become available, with a preference for holding cash or investing in short-term holdings that quickly return cash for possible redeployment when available returns are more attractive... Dividend discount model not useful… Once future cash flows are forecast conservatively and an appropriate discount rate is chosen, present value can be calc’d. In theory may assign probability to a few cash flow scenarios… Private market value method; buyers of businesses do not necessarily pay reasonable, intelligent prices…At most, private market value should be used as one of several inputs in the valuation process and not as the exclusive final arbiter of value… Liquidation value; intangibles not considered; theoretical exercise but not an actual approach to value realization… Value of PP&E depends on its ability to generate cash flows. Some are widely used and transferable, others are not… Need to consider off balance sheet or contingent liabilities such as underfunded pension plans and those (environmental for example) that might be incurred in liquidation… Stock MKT value one of several valuation tools and provides a yardstick of what a security worth now… NPV best way to value stable business and cash flows and liquidation best for unprofitable business… Conservatism may cause investors to refrain from making some investments in hindsight would have been successful, but it will also prevent some sizeable losses… Complicated matter is the reflexive nature of the value of the business; ability to raise capital at favorable levels is important; stocks and debt. Same thing true of managers who believe market is right; stock may be undervalued but believe MKT is right; sell stock and dilute, etc… Discussion on spin-off of small company i.e. HYH, CRC, LE, investors just sell and a lot of times historical or pro-forma not evident or available. Defense stocks liquidation analysis not applicable as cannot easily be liquidated or no recent transactions… Esco: 3x earnings when factoring special charges and amort. and was only 40% of net working capital… Both earnings and book value have a place in securities analysis but must be used with caution and as part of a more comprehensive valuation effort; the accounting is subject to manipulation and as with any prediction of the future, earnings are nearly impossible to forecast… GAAP may require actions that do not reflect business REALITY; requires amort. of good will etc. MOST IMPORTANT, whether use EPS or cash flow, important to remember that numbers are not an end to themselves, rather a means of understanding what is happening right now… PP&E may be worth considerably less or more less than stated value, two companies with identical tangible assets and liabilities may have very different reported book values. As with earnings, book value provides limited information to investors and should be considered as one component of more thorough and complete analysis… MANY BUSINESS ARE SO DIVERSE OR DIFFICULT TO UNDERSTAND THAT THEY SIMPLY CANNOT BE VALUED… For every business that cannot be valued, there are many others that can be. Investors who confine themselves to what they know, as difficult as that may be, have a conservable advantage over everyone else…. Good investment ideas are rare and valuable things, which must be ferreted out assiduously…  UPON OCCASION ATTRACTIVE INVESTMENT OPPORTUNITIES ARE SO NUMEROUS THAT THE ONLY LIMITING FACTOR IS THE AVAILABILITY OF FUNDS TO INVEST- NOW IS NOT ONE OF THOSE TIMES, BUT WE WILL ACTIVELY STRIVE TO BE POSITIONED APPROPRIATELY WHEN THAT TIME COMES. In the meantime, there should be selective opportunities to uncover value and capitalize on non-economic selling... Value investing encompasses a number of specialized in to 3 categories: 1) securities selling at a discount to breakup or liquidation value 2) rate of return situations 3) asset conversion opportunities (transformations) … Look at percentage decline and new low lists… Look at low priced spinoffs; year-end tax-selling… When investors in 1983 ignored or panned Nabisco, causing it to trade at a discount, the risk-reward ratio became more favorable… No matter how much due diligence is performed, some information always remains elusive. Most investors strive fruitlessly for certainty and precision, avoiding situations in which information is difficult to obtain. Yet, high uncertainty is frequently accompanied by low prices. Investors frequently benefit from making investment decision with less than perfect knowledge and are well rewarded for bearing the risk of uncertainty. THE TIME OTHER INVESTORS SPEND DELVING INTO THE LAST UNANSWERED DETAIL MANY OCOST THEM THE CHANCE TO BUY IN AT PRICES SO LOW THAT THEY OFFER A MARGIN OF SAFETY OF INCOMPLETE INFORMATION… Investment research is the process of reducing large piles of information to manageable ones, distilling the investment wheat from the chaff. The research process itself, like the factory of a manufacturing company, produces no profits. The profits materialize later, when the undervaluation during the research process is first translated into portfolio decisions (Abrams Western Union; can be drastically later) and then eventually recognized by the market.  In fact, often there is no immediate buying opportunity, today’s research may be advance preparation for tomorrow’s opportunities. In any event, just as a superior sales force cannot succeed if the factor does not produce quality goods, an investment program will not long succeed if high quality research is not performed on a continuing basis... The securities of high-return businesses therefore reach compelling levels of undervaluation only infrequently. Usually investors have to work harder and dig deeper to find undervalued opportunities, either by ferretting out hidden value or by comprehending a complex situation… Value investors are always on the lookout for catalysts. While buying assets at a discount from underling value is the defining characteristic of value investing, the partial or total realization of underlying value through a catalyst is an important means of generating profits. Furthermore, the presence of a catalyst serves to reduce risk. OWNING SECURITIES WITH CATALYSTS FOR VALUE REALIZATION IS THEREFORE AN IMPORTANT WAY FOR INVESTORS TO REDUCE THE RISK WITHIN THEIR PORTFOLIOS, AUGMENTING THE MARGIN OF SAFETY ACHIEVED BY IVNESTING AT A DISCOUNT FROM UNDERLYING VALUE… Look for spinoffs no one wants. The highly unusual nature of these securities ensured very limited demand from institutional and individual investors and increased the likelihood that they would at times become undervalued compared with other publicly traded options. Rights offerings can compel current shareholders to put up more money in order to avoid considerable dilution of their investments… Risk arbitrage is a highly specialized area of value investing, yet far from riskless. Spinoffs, liquidations, and corporate restructurings, which are sometimes referred to as long term arbitrage, also fall into this category… At times of high investor uncertainty, risk arbitrage related securities may become unusually attractive… In a sense there is a cycle of investment results attendant to any investment philosophy or market niche due to the relative popularity or lack of popularity of that approach at a particular time… Shareholders receiving the spinoff shares will find still other reasons to sell, they may know little or nothing about the business that was spun off and find it easier to sell than to learn; large institutional investors may deem the newly created entity too small to bother with; and index funds will sell regardless of the price if the spinoff is not a member of their assigned index. Wall Street analysts do not usually follow spinoffs… Some spinoffs may choose not to publicize the attractiveness b/c they prefer a temporarily undervalued MKT price as MGMT may receive options based on initial trading prices; can also be two or 3 month lag on good information (BOUGHT BNI AND SHORTED BR in order to lock in new business.) Attractive opportunities arise with some frequency in a number of areas and that these opportunities can be identified and exploited by value investors… Distress: as soon as new lenders can be assured of their senior creditor position, debtor in possession financing becomes available, providing cash to meet payroll, to restock depleted inventories, confidence renewed, cash often starts to rebuild. One attractive feature of the reorg process is that it can serve as a catalyst for realizing underlying value. In the illiquid market for distressed and bankrupt bonds, being a smart trader may sometimes be more important than being a smart analyst… An investor’s portfolio management responsibilities include maintaining appropriate diversification, making hedging decisions and managing portfolio cash flow and liquidity… Attractive returns earned by Heinz may not correlate with the returns achieved by investors in Heinz the price paid for the stock, and not just business results, determines their return… During a market panic the liquidity that seemed miles ide in the course of an upswing may turn out only to have been inches deep. The tension b/w earning a high return on the one hand, and avoiding risk, on the other, can run high… The cash flowing into a portfolio can reduce an investor’s opportunity costs. Second, the periodic liquidation of parts of a portfolio has a cathartic effect.


When securities in a portfolio frequently turn into cash, the investors is constantly challenged to put that cash to work, seeking out the best values available… As few as 10-15 holdings usually suffice (appropriate diversification). Diversification for its own sakes is not sensible… The best investment opportunities arise when other investors act unwisely thereby creating rewards for those who act intelligently. When others are willing to overpay for a security, they allow value investors to sell at premium prices or sell short at overvalued levels. When others panic and sell at prices far below underlying business value. When their actions are dictated by arbitrary rules or constraints they will overlook outstanding opportunities or perhaps inadvertently create some for others. Trading is the process of taking advantage of such mispricings… Some investors buy and hold for the long term, stashing their securities in the proverbial vault for years. While such a strategy may have made sense at some time in the past it seems misguided today. This is because the financial markets are prolific creators of investment opportunities.  Investors must learn to resist fear, the tendency to panic when prices are falling, and greed, the tendency to become overly enthusiastic when prices are rising… If prior to purchase, you realize that you are unwilling to average down, then you probably should not make the purchase… Many investors are able to spot a baring but have a harder time knowing when to sell. One reason is the difficulty of knowing precisely what an investment is worth. An investor buys with a range of value in mind at a price that provides a considerable margin of safety. As the market price appreciates, however, the safety margin decreases. There is only one valid rule for selling, all investments are for sale at the right price. “You have to feed the birds when they are hungry…” Did the manager achieve good results despite high cash balance? Personal compatibility with a manager.


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