Seth Klarman is a legendary value investor with some $25B in assets
under management at his Baupost Group.
In 1991 he released a book called “Margin of Safety – Risk Averse Value
Investing Strategies for the Thoughtful Investor” which has become something of a
must-read among sophisticated investors.
Unfortunately, it is out of print, and a physical copy
cost $2,000 to get from Amazon.
One can only speculate of WHY
Mr. Klarman decided not to make a second edition,
there’s clearly demand for it these days.
Is it because he’s already wealthy enough so he just doesn’t care?
Is it because he offended some group of people that doesn’t like being offended?
Or is it because he thought that maybe he revealed a little too
much of his investing secrets?
I don’t know.
But I had to get a copy myself, in order to bring you guys
this top 5 takeaways summary.
Let’s dive in!
This is The Swedish Investor, bringing you the best tips and tools
for reaching financial freedom, though stock market investing.
Takeaway 1: What’s the Difference Between a Value Investor & a Speculator?
Seth Klarman is clearly influence by Warren Buffett and Benjamin Graham,
he even choose to name his book from Graham’s concept – the margin of safety.
As such, he is a value investor down to the core.
What does it mean to be a value investor according to Klarman?
Well, Klarman seems to divide investors into two camps.
Value investors and speculators.
Not unlike what Buffett does, by the way.
His right-hand man Charlie Munger may have said it best:
I don’t think that value investing will ever go out of style.
Who in the hell doesn’t want value when you buy something?
How can there be anything else that makes any sense except value investing?
What’s the most important difference between these two
groups according to Klarman?
It’s that value investors focus on business cashflows, while speculators
focus on the value in the resell market.
Value investors buy securities when they seem to offer good returns
for the risk incurred, and sell when this no longer holds true.
Speculators, on the other hand, only buy or sell when they think that the
price of securities will rise or fall.
Their ideas about future price movements are based on what they
think that others will be doing.
Now a clever man would put the poison into his own goblet,
because he would know that only a great fool would reach for what he was given.
I'm not a great fool so I can clearly not choose the wine in front of you.
But you must have known I was not a great fool, you would have
counted on it, so I can clearly not choose the wine in front of me!
Why is it so stupid to make judgement calls based on price alone?
Because it is never clear which future events that are already
priced in at today’s levels.
Therefore, value investors always compare price to underlying business value.
Art, antiques, rare coins, pokemon cards, cryptos, these things are not
investments but pure speculation, simply because they do not produce
anything valuable to other people and so they do not produce any cash.
The only time they may throw off cash is when you sell them.
And the problem is that the buyer must also think that he’ll eventually be
able to sell the asset to someone else at an even higher price,
otherwise he wouldn’t want to buy, right?
Machines makes stuff that people want, buildings pay rent, subscription
software creates reoccurring revenues, loans issued pay interest
– these are the things for value investors.
If these cash flows can be purchased at a reasonable price relative to their
potential of growing in the future, and most importantly, the risk that
they might disappear in the future, Seth Klarman is an interested buyer.
That’s what’s up next.
Takeaway 2: Investment Risk – A Terribly Misunderstood Concept
You’ve probably heard that Warren Buffett’s first rule of investing is to
never lose money, and that his second rule is to never forget rule number one.
This does not mean that you should never have a down year in the
stock market, trying to guard yourself against that is impossible.
It does mean that, over several years, you should invest in a way
that ensures that you’ll never experience any material losses.
Value investors like Klarman & Buffett are incredibly focused on this downside
– on investment risk.
Why are they so obsessed with it?
Because, in investing, simply put, if you can remove the downside,
the upside will take care of itself.
Risk for a value investor boils down to two things – the nature of the asset
that you are purchasing, which determines the degree of cashflow certainty,
and the price that you are paying for it.
The cash flows from a company with a long history in a slow-changing industry,
like McDonald’s for example, are very low risk.
So, McDonald’s fulfils our first criteria for a low-risk investment.
However, it does sell at a P/E of 32 or EV/EBIT of 25 currently,
and that’s not exactly cheap.
You can still lose money here if that P/E multiple were to go down to, say, 18.
So, it’s always a two-part equation.
Investment risk is a terribly misunderstood concept.
Klarman takes a major stab at professors teaching finance who think that Beta,
or price volatility, is the main determinant of investment risk.
This misconception has spread like a plague,
even to some professionals on Wall Street.
Beta is a terrible measurement of risk
because it fails to take the nature of the asset AND its price into account.
Perhaps the worst manifestation of all this nonsense, is the Capital Asset
Pricing Model, or CAPM, which states that greater returns will be achieved by those
who are willing to accept greater risks.
They got it completely back-ass-wards.
To the contrary, risk erodes returns by causing losses.
For instance, small cap stocks are often said to yield higher returns than
large caps because they are riskier.
But if a higher return is a given, are they really that risky?
No, price volatility isn’t a good predictor of future performance, heck,
it’s not even that good of a predictor of future volatility, says Klarman.
Takeaway 3: Three Methods of Valuing a Stock
A value investor does not wake up in the morning knowing his buy and
sell orders for sure, these will always be determined depending on the
relationship between value and price.
While price is easy to see, just log on to Yahoo Finance and check
where it’s at, how do you determine the value-side of this equation?
Klarman has three different methods that he suggests:
Liquidation or Breakup Value
A simple way of valuing a company is to look at its balance sheet and see
what the value of all its assets are.
If you sum up all the assets and deduct all the liabilities,
you’d get a theoretical value if the company was to liquidate.
Most profitable businesses isn’t interested in shutting down though,
and most of their value does not come from the balance sheet, but rather from
their income and cashflow statements.
However, liquidation value can still represent some sort of “floor” or
“cushion”, especially if these assets consist of tangible, liquid stuff,
like cash or marketable securities.
Sometimes, even a profitable business sells for less than the net value
of such assets, and that could be an interesting investment opportunity.
Stock Market Value
Another simple way of valuing a company is by looking at its earnings and cashflow
and see how they trade in relation to other similar securities in the market.
For example, if semiconductor manufacturer A is valued at P/E 20
while the industry average is P/E 30, you might argue that A has a 50%
upside, just in multiple expansion.
Klarman thinks one must be very careful with this approach, though.
The market could be wrong on a whole industry
just like it could be wrong on a single company.
However, in something like a spinoff situation, when a company is going
to list one of its subsidiaries, this approach is the most appropriate one.
Discounted Cashflow Analysis [DCF]
If you sum up the cashflows of an investment from today until judgment day,
and you use a proper discount rate, you’ll get its theoretical value.
This approach works best for a business with strong prospects.
You must be able to say something about its future with some
degree of certainty, because the calculations are very sensitive to
assumptions about growth rates etc.
The method is theoretically correct for any type of investment,
but one must be careful as there’s a high risk for “garbage in, garbage out”.
At times, a combination of different valuation methods gives the best result,
especially with widely diversified businesses
such as Warren Buffett’s Berkshire Hathaway.
However you chose to use them, the main point is this:
Any time you come up with a value which is
quite a bit higher than the security’s current price,
you’ve got a margin of safety.
When investing, you must insist on a margin of safety.
Why?
Consider this: A real estate agent cannot appraise the value of
your home to the nearest $10,000.
Therefore, it isn’t reasonable to expect something more complicated,
like business valuation, to be a very precise science either.
Takeaway 4: To Hold, or Not to Hold … Cash
If you’ve been watching this channel for some time, you probably know
that I think opportunity costs may be the most important concept
that investors must learn about.
If you put your money in stock A you cannot allocate
those resources to stock B.
In fact, you cannot allocate the money to stock C, D, E, F, G or H either,
and that’s really tough when B, C, D, E, F, G or H overperformed
your own choice, which was A.
So chose well!
Seth Klarman discusses another dimension of opportunity cost of investing.
Have you ever sat through a huge market dip,
whishing that you had some cash on hand?
I sure have, and that represents an opportunity cost too.
By being fully invested all the time,
you forego the opportunity of investing a ton of cash at a market bottom.
The choice of being fully invested or partly in cash is complex,
and Klarman’s advice on this matter is really refreshing,
because there is a middle-road.
Imagine that you’ve found a company with a 10% dividend yield.
You buy it and then the market crash by 50%.
You think: “Damn, I should have stayed in cash!”
But then you remember,
you still have your dividend!
Within a year, you’ll get 10% of your original investment back
in dividends, which could be reinvested in the cheap market.
Not so bad, after all.
A high dividend company isn’t even the best in class, by the way.
We talked about valuing a company based on the liquidation of assets earlier.
Such companies can throw off tons of cash at just the right moment
if a market turn is around the corner.
The same goes for something like a merger arbitrage opportunity,
you’ll get your invested capital back really soon
and you are ready to redeploy it at that point.
This is the general idea:
If you think that the market is in for a crash,
it’s oftentimes a bad idea to act on it by sitting in cash.
More often than not, you’ll be getting out of the market while
all your friends stay and get rich.
Money itself isn't lost or made, it's simply, transferred
- from one perception to another.
Like magic.
What you can do instead is chose to invest in situations where lots of
your invested cash should be returned in the near future by investing in,
for example, high dividend payers, liquidations or merger arbitrages.
That way, you are not sitting on the sidelines, and you’ll be ready
with cash if that collapse that you are expecting really is coming.
Awesome!
Takeaway 5: Apply the 80/20 Approach
Do you know someone who would gladly wait half a day outside of
Walmart on Black Friday, just to get a $100 discount on their TV?
Perhaps the same person who does weeks of research before buying
something like a new washing machine.
But then, when it comes to his $10,000 investment in TSMC,
that decision was made on a whim.
I hope it is obvious that you don’t want to be this person.
However, you also don’t want to be the person who spends weeks researching a
single stock just to miss the opportunity.
Seth Klarman suggests something of an 80/20 approach towards
investing in the stock market.
It’s better to spend most of your time shuffling through many opportunities
than to go really deep on any of them.
Otherwise, you’ll become like old Bilbo Baggins:
I don't know half of you half as well as I should like, and I like less than
half of you half as well as you deserve.
Oftentimes the really great ideas don’t require that much of
research anyways, they should be what some call “a screaming buy”.
They got that margin of safety and it is quite obvious if you just
spotted them at the right moment.
You’ll have to turn many stones, but don’t think that those opportunities
that you shut down is wasted time!
One of the wonderful benefits with investing is that all
knowledge is cumulative.
Yesterday’s insights could be useful sooner than you think.
- So: Focus on cashflows rather than resell price
- Investment risk is a combination of cashflow certainty and price
- You can value a stock by using either the liquidation, market value or DCF method
- If you find the market expensive, make sure that cashflows arrive earlier.
And, a lot of your time as an investor should be spent shuffling through many ideas.
Next, why don’t you check out how the father of value investing, Benjamin Graham,
made his first $1,000,000?
Cheers guys!