Having been lucky enough to obtain a copy, I just completed Seth Klarman’s Margin of Safety. Overall, the short book was an enjoyable read. Perhaps due to a supply/demand imbalance (the publisher has long since stopped producing print copies), the book sells for ~$2500 online. Reflexively, the title’s scarcity has bestowed upon it an intrinsic value, and it’s achieved mythical status akin to the Great & Powerful Oz.
Because of the hype, I’m left underwhelmed. I didn’t expect to learn of some investor’s panacea, but I expected something a bit more timeless. A large portion of the book is dedicated to case studies, none of which failed to transpire profitably. The book would’ve benefitted from a bit more humility, as would have the reader from examples of “learning from mistakes” or other such evolutionary episodes. Mr. Klarman’s anecdotes are terrific little nuggets of history for my brainbox; in fact, they’re organized, exemplary, and memorable in such a way that so many other books are not (see Manias, Panics & Crashes: A History of Financial Crises). Yet, these nuggets are all way too rudimentary to be of any use to a practitioner–an irony given the author’s repeated insistence that substantial value opportunities are hard to find.
Mr. Klarman is a value purist whose approach reminds me of Joel Greenblatt’s radically pragmatic and simplistic appeal to common sense (see The Little Book That Still Beats the Market). Baupost’s 30-50% cash positions have become something of folklore, and that conservatism drips off the pages in Mr. Klarman’s ‘if I can’t find value with a margin of safety, I patiently hold cash and keep digging’ attitude–reminiscent of the Jim Rogers philosophy.
An early chapter provides a good example of the whole book’s cadence. During the junk bond craze of the 1980s, LBOs spurred an M&A boom. Given the velocity of transactions, investors started using EBITDA over EPS as a “more relevant” indication of a company’s cash flow. Think about it: interest on high yield debt is tax deductible, depreciation is a non-cash expense against earnings (smoothing out GAAP results & taxable net income), and amortization of goodwill is also a non-cash charge against earnings.
Two assumptions papered over reality in the shift to dependence on EBITDA. First, few analysts considered capital expenditures when valuing companies, because, second, companies kept achieving growth by either acquiring or being acquired.
CapEx, is a post-EBITDA cost. As a form of investment, it’s not only crucial for a company’s organic growth and maintenance, but it’s also inevitable (machinery grows old and needs replacement eventually). Taking depreciation without continually investing in capital (PP&E), companies were fattening their short term EBITDAs to attract buyers–like cattlemen waterlogging livestock before an auction. These companies had to generate real cash (not accounting cash) at some point, which required investment, which circuitously required cash.
Similarly, if a company acquires another at a fat premium, the value above tangible book gets recorded as goodwill, which (until 2001) GAAP allowed companies to amortize over 40 years. This goodwill amortization also juiced EBITDAs for the purpose of window dressing. Plus, the deductibility of interest also encouraged leverage for the sake of EBITDA–even at the expense of economic value (EPS).
In such a way, EBITDA was insufficient as an indicator of a company’s true cash position and cash generating potential. Earnings indicate the return on a company’s investment (profit), while depreciation & amortization merely the return of a company’s investment (cost). Those are two very different things when you’re concerned about sustainability and future value.
Mr. Klarman’s point here was that Wall Street perpetrated the paradigm shift to EBITDA valuation, and you must always watch for the sleight of hand, the illusion that tries to divert your eyes from the ball:
“EBITDA may have been used as a valuation tool because no other valuation method could have justified the high takeover prices prevalent at the time. This would be a clear case of circular reasoning. Without high-priced takeovers there were no upfront investment banking fees, no underwriting fees on new junk-bond issues, and no management fees on junk-bond portfolios. This would not be the first time on Wall Street that the means were adapted to justify an end. If a historically accepted investment yardstick proves to be overly restrictive, the path of least resistance [for special interests] is to invent a new standard.“
Mr. Klarman says, “Investment research is the process of reducing large piles of information to manageable ones.”¹ He suggests that an investor can spend all his time looking for ideas, but he should start with 3 broad niches:
- Deep value- securities trading below liquidation value
- Arbitrage- event, capital structure, derivatives, complex securities, etc.
- Distressed- reorg or bankruptcy situations that fetch deep discounts
Then, move on to analyzing candidates, with a central theme in mind:
“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.”
To wit, the rules of value investing and maintaining a profound margin of safety:
- Ask why assets appear undervalued– are the company’s products inferior; are there technical dislocations (e.g. low priced stock or recent dividend cut); are there off-balance sheet liabilities, underfunded pensions, or pending litigations; does the company face a breakup, orderly liquidation, or firesale; and do the assets have a natural buyer or alternative use?
- Be conservative in valuation method– value is not an exact number, so assume worst case liquidation values for assets, use a conservative (higher) discount rate in NPV/DCF models, and pay only what you yourself actually would for asset comps; tiny variations in future assumptions can dramatically affect NPV, thus conservative projections minimize the impact of uncertainty by skewing expectations toward the negative surprise and leaving disproportionate probability of a positive surprise
- Give preference to tangible assets over intangible
- Look for a catalyst through which value will be realized– acknowledge the risk of time horizon
- Give preference to good management teams with personal stakes in their companies– there are many reasons for insiders to sell, but only one reason for them to buy
- Don’t feel pressured to buy– be disciplined enough to hold cash when assets appear overvalued; be faithful enough to keep hunting for bargains (they’re not easy to find because the market is biased toward overvaluing securities); focus on absolute performance, not relative, such that you never worry that the market’s running away from you
- Only buy securities at a significant discount from their current underlying values– buy $1 for $0.50
- Hold securities until value is realized or a replacement promises better value
Mr. Klarman redefines risk. Because they’re transitory, market price fluctuations are not a risk to a true value investor; value impairment is the real risk, due to permanence. He targets risk, not return. Only invest in risk assets if they promise considerably higher risk-adjusted returns than can be achieved risk free (T-bills).
In that vein, Mr. Klarman emphasizes the difference between the long term value investor and a short term speculator. Investments spin-off cash flow for their investors, who determine underlying value that sets a price floor beneath market price. This clairvoyance gives the schooled investor confidence, as value is the only inconvertible truth in the marketplace.
Again, I’m critical of this book because of the hype more than anything else. Despite my criticisms, I enjoyed the read, and I’ll re-read this again many times in the future.
More importantly, I learned something here. I’m again reminded of Joel Greenblatt when I summarize my affinity for Margin of Safety: while the work itself is not worthy of the illustrious acclaim, it has meaningfully changed me as an investor by retooling my approach. The book itself is not beautifully written, it is not all that innovative, and it does not say anything someone else has not or can not say themselves, but it reminds me of the basics, in that common sense outlives every fad.
How will I implement the lessons learned herein?
- Reemphasize fundamental analysis– While I’ve always approached portfolio management via a hybrid analytical process, I’ve strayed recently towards an overemphasis on technicals. I will continue to identify opportunities via my evolving quantitative screens (some of which I’ve tweaked in the wake of reading this book), but I will dive deeper in my subsequent fundamental research, asking ‘why’ value may exist on a balance sheet, recalculating assets & liabilities with a conservative (worst case) skew, and relying less on predictions & trend extrapolation, from which bias proliferates.
- Reemphasize absolute performance over relative– That starts with a commitment to long term returns, which means I must stop wasting energy tracking intraday performance (+/- SPX) and retrain myself to focus on the full year. The war is more important than its individual battles.
- Reallocate my time– Obsessive daily or weekly position monitoring is counterproductive–even for tracking technicals. Only check in on charts when necessary (e.g. a foreseen development is materializing or an unforeseen evolution occurs). A quarterly timeframe is only relevant for risk management, specifically intended for reaffirming the value (or confirming value impairment) of singlename holdings. The balance of my investment management time should be spent looking for new ideas.
- Establish bright line between trades & investments– Earmark holdings as either short term trades or long term investments, and if one becomes the other, I must revisit my initial impetus to explicitly attribute and verify the transgression. Whether equity or fixed income, index/ETF holdings are more suitable as trading vehicles; singlenames are best as investments, bought near liquidation value and held until fair value is realized.
- Refrain from opening full positions– I do generally start by buying half positions, but I can do a better job of waiting for technical confirmation and being patient throughout execution, especially when the tape starts running away from me. (Remember, if I’m managing for absolute return, I don’t have an index to keep up with; my goal is to make–not lose–money.)
¹I think that affirms my own approach, which begins with a quantitative screen that distills a universe of ~996,000 global equities down to a filtered watch list.