11/06/2017
Equity Mates Book Review #1
Margin of Safety – Seth A. Klarman
Listen to our review in Episode 11
If you are interested in value investing, Seth Klarman is a name you need to know. While Warren Buffett has become synonymous with the value investing ethos Klarman may one day be looked at in the same light. He’s already been dubbed the ‘Oracle of Boston’ (a homage to Buffett’s ‘Oracle of Omaha’) and the story goes that Buffett keeps a copy of Margin of Safety on his bookshelf. As the Chief Executive and Portfolio Manager of Baupost Group, Klarman has seen some spectacular results. In fact ,he has only lost money 3 out of the last 34 years, and has seen an 20% compounding annual growth rate (i.e. average out his investment performance and he is making 20% a year – a pretty remarkable figure).
Basically, when Klarman speaks we should all listen. That is was why his book Margin of Safety was a natural choice for our first Equity Mates book review.
The book itself is worth quickly touching on. Only 5,000 copies were printed in 1991 and none have been printed since. So while they originally sold for $25 they now sell in the hundreds, or even thousands of dollars. Libraries report it as one of their most ‘unreturned’ books. However, if you can get your hands on a copy it is well worth your time.
While Klarman gets deep into the weeds of value investing in the later section of the book, there are also some excellent take-aways for investors of any level.
1. Are you investing or speculating?
Many people would assume that if you’re buying shares, you’re investing. However, Klarman makes the point that to make that assumption is to miss a key distinction. That is, how you expect to earn a return from the shares you are buying.
When you invest you are expecting to benefit from the free cash flow generated by the underlying business. So, put simply, as the business makes profit you expect to benefit either via dividends or by the business using these profits to grow and for the share price to rise accordingly. That is investing – benefiting from the money generated from the underlying business.
He compares this to speculating, where you buy a share with the expectation of making money because others will be willing to pay more for it in the future. In essence, the only way you make money as a speculator is to find a greater fool – someone who is willing to pay more for the asset than you were willing to pay. If you cannot, you are the greater fool.
He writes:
“Both investments and speculations can be bought and sold. Both typically fluctuate in price and can thus appear to generate investment returns. But there is one critical difference: investments throw off cash flow for the benefit of the owners; speculations do not. The return to the owners of speculations depends exclusively on the vagaries of the resale market.”
This doesn’t just apply to investing in shares. If you are buying art or vintage cars you are doing it under the assumption that someone will be willing to pay more for it in the future. In that way you are making a prediction of human behaviour rather than the value of the asset or business. That, Klarman argues, is a much riskier proposition.
2. The Institutional Performance Derby
The Institutional Performance Derby is the terminology Klarman uses to criticise hedge funds and the incentive structures of big institutions. There are two main issues for Klarman.
The first is that the incentive structure for Wall Street is misaligned. Essentially, institutions make their money on activity and transactions (i.e. brokerage on trades, underwriting new securities, commission for certain investments) – regardless of the outcome of these activities for the investor. For investment funds – more money is made as a percentage of money under management rather than the performance of that money. So funds are incentivised to raise more money from investors instead of extracting better performance out of their existing capital. In this way incentive structures are misaligned and the loser in many cases is the individual investor.
The second issue is Wall Street’s short term, and relative, focus. The hyper-competitive nature of Wall Street means that very few investors are willing to embrace a long time horizon and instead they focus on quarterly results. Similarly, rather than measuring themselves in absolute terms a lot of Wall Street investors measure performance relatively – i.e. against each other.
Klarman writes:
“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.”
3. Investment Fads
Klarman wrote this book in 1991, coming off the high flying corporate rollercoaster than was the 1980’s. It was the decade of corporate raiders, leveraged buyouts and Reaganomics. When Donald Trump shot to prominence and “Greed is good” was the mantra of the time. This decade saw the growth of investment fads and their consequences.
One such fad was the growth of risk arbitrage – which essentially involved investors betting on proposed mergers or acquisitions being successful. Yet as more and more investors flocked to that style of investing, the prices that investors had to pay grew and that shrunk the available profits. What’s more, as more investors adopted this strategy the risks investors had to take to continue to find these deals grew. Then in the late 1980’s some big deals collapsed, the recession hit and a lot of investors lost money following the risk arbitrage game. Similarly, the 1980’s saw the fad of investing in companies with ‘business franchises’ and also in junk bonds. While the investment product may be different each time, the result is the same. A flood of money into that sector or asset class, driving up prices and squeezing potential return. A greater appetite for risk because as prices rise there is a greater perception of safety. Then as potential profits dry up, money leaves that investment fad and a lot of investors lose money.
While Klarman wrote this book before the tech boom of the 1990’s – we can see the same process repeated itself. Initial investors were seeing success, so a flood of other investors jumped into tech stocks. As prices rose and more investors joined the party, riskier and riskier technology companies floated onto the stock exchange. Some of these companies were so risky that they weren’t even making money – but the fact they were technology stocks meant investors loved them. Then, when the tech bubble burst, a lot of these companies were found out and a lot of investors lost a lot of money.
For this reason Klarman warns against the investment fad of the day. As more and more investors follow the crowd this distorts the balance of risk-reward. Instead, disciplined investors should stick to the fundamentals, finding good companies that can be bought for a great price.
4. True Value Investing
Klarman discusses in detail his principles for true value investing, which are far too detailed and thoughtful to do justice in this review. However there are a few principles that are worth listing for everyone to take with them on their investing journey.
- Do everything you can not to lose the capital (money) you’ve invested. That is why you must always invest with a margin of safety.
- Take a bottom-up approach when selecting investments. Don’t select an industry that you will invest in and then choose a company from that industry. Instead, always start your analysis at the company level and find companies that are undervalued.
- Invest with a focus on absolute performance and with a long time horizon. Don’t get caught up in short-term price fluctuations or how your investment is doing compared to other shares. Always focus on consistent, absolute returns over a long time.