Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor by Seth Klarman

The Book in Three Sentences

Avoiding loss should be the primary goal of every investor. The way to avoid loss is by investing with a significant margin of safety. A margin of safety is necessary because valuation is an imprecise art, the future is unpredictable, and investors are human and make mistakes.

Margin of Safety summary

This is my book summary of Margin of Safety by Seth Klarman. My notes are informal and often contain quotes from the book as well as my own thoughts. This summary includes key lessons and important passages from the book.

• Investors are frequently lured by the prospect of quick and easy gain and fall victim to the many fads of Wall Street.
• Value investing, the strategy of investing in securities trading at an appreciable discount from underlying value, has a long history of delivering excellent investment results with very limited downside risk.
• It is easy to stray but a continuous effort to remain disciplined.
• Avoiding where others go wrong is an important step in achieving investment success. In fact, it almost ensures it.
• Value investing requires a great deal of hard work, unusually strict discipline, and a long-term investment horizon.
• It is necessary instead to understand the rationale behind the rules in order to appreciate why they work when they do and don’t when they don’t.
• The correct choice for investors is obvious but requires a level of commitment most are unwilling to make.
• Most investors are primarily oriented toward return, how much they can make, and pay little attention to risk, how much they can lose.
• A margin of safety is necessary because valuation is an imprecise art, the future is unpredictable, and investors are human and do make mistakes.
• Value investors invest with a margin of safety that protects them from large losses in declining markets.
• once you adopt a value-investment strategy, any other investment behavior starts to seem like gambling.
• To investors stocks represent fractional ownership of underlying businesses and bonds are loans to those businesses.
• In reality, no one knows what the market will do; trying to predict it is a waste of time, and investing based upon that prediction is a speculative undertaking.
• There is comfort in consensus; those in the majority gain confidence from their very number.
  (Note: This is a great way to think about why we go along with the crowd, “the comfort of consensus.”)
• But there is one critical difference: investments throw off cash flow for the benefit of the owners; speculations do not.4 The return to the owners of speculations depends exclusively on the vagaries of the resale market.
• Stocks and bonds go up and down in price, as do Monets and Mickey Mantle rookie cards, but there should be no confusion as to which are the true investments
• Investments, even very long-term investments like newly planted timber properties, will eventually throw off cash flow. A machine makes widgets that are marketed, a building is occupied by tenants who pay rent, and trees on a timber property are eventually harvested and sold.
• It is vitally important for investors to distinguish stock price fluctuations from underlying business reality.
• prices move up and down for two basic reasons: to reflect business reality (or investor perceptions of that reality) or to reflect short-term variations in supply and demand.
• avoiding loss should be the primary goal of every investor.
• the avoidance of loss is the surest way to ensure a profitable outcome.
• the actual risk of a particular investment cannot be determined from historical data. It depends on the price paid.
• the effects of compounding even moderate returns over many years are compelling, if not downright mind boggling.
• A corollary to the importance of compounding is that it is very difficult to recover from even one large loss, which could literally destroy all at once the beneficial effects of many years of investment success.
• an investor is more likely to do well by achieving consistently good returns with limited downside risk than by achieving volatile and sometimes even spectacular gains but with considerable risk of principal.
• An investor who earns 16 percent annual returns over a decade, for example, will, perhaps surprisingly, end up with more money than an investor who earns 20 percent a year for nine years and then loses 15 percent the tenth year.
• Investors must be willing to forego some near-term return, if necessary, as an insurance premium against unexpected and unpredictable adversity.
• Rather than targeting a desired rate of return, even an eminently reasonable one, investors should target risk.
• Treasury bills are the closest thing to a riskless investment; hence the interest rate on Treasury bills is considered the risk-free rate.
• 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.
• An investment must be purchased at a discount from underlying worth.
• Above all, investors must always avoid swinging at bad pitches.
• First, since investors cannot predict when values will rise or fall, valuation should always be performed conservatively, giving considerable weight to worst-case liquidation value as well as to other methods.
• Graham was only interested in buying at a substantial discount from underlying value. By investing at a discount, he knew that he was unlikely to experience losses. The discount provided a margin of safety.
• Because investing is as much an art as a science, investors need a margin of safety. 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. According to Graham, “The margin of safety is always dependent on the price paid. For any security, it will be large at one price, small at some higher price, nonexistent at some still higher price.”
• How can investors be certain of achieving a margin of safety? By always buying at a significant discount to underlying business value and giving preference to tangible assets over intangibles. (This does not mean that there are not excellent investment opportunities in businesses with valuable intangible assets.) By replacing current holdings as better bargains come along. By selling when the market price of any investment comes to reflect its underlying value and by holding cash, if necessary, until other attractive investments become available.
• Give preference to companies having good managements with a personal financial stake in the business.
• A market downturn is the true test of an investment philosophy.
• A notable feature of value investing is its strong performance in periods of overall market decline. Whenever the financial markets fail to fully incorporate fundamental values into securities prices, an investor’s margin of safety is high.
• Value investing is, in effect, predicated on the proposition that the efficient-market hypothesis is frequently wrong.
• The efficient-market hypothesis takes three forms.3 The weak form maintains that past stock prices provide no useful information on the future direction of stock prices. In other words, technical analysis (analysis of past price fluctuations) cannot help investors. The semi-strong form says that no published information will help investors to select undervalued securities since the market has already discounted all publicly available information into securities prices. The strong form maintains that there is no information, public or private, that would benefit investors. The implication of both the semi-strong and strong forms is that fundamental analysis is useless.
• Of the three forms of the efficient-market hypothesis, I believe that only the weak form is valid.
• Specifically, by finding securities whose prices depart appreciably from underlying value, investors can frequently achieve above-average returns while taking below-average risks.
• The pricing of large-capitalization stocks tends to be more efficient than that of small-capitalization stocks, distressed bonds, and other less-popular investment fare.
• Investors are more likely, therefore, to find inefficiently priced securities outside the Standard and Poor’s 100 than within
• many buyers and sellers of securities are motivated by considerations other than underlying value and may be willing to buy or sell at very different prices than a value investor would.
• The behavior of institutional investors, dictated by constraints on their behavior, can sometimes cause stock prices to depart from underlying value.
• “Value investing” is one of the most overused and inconsistently applied terms in the investment business.
• Value investing is simple to understand but difficult to implement.
• The hard part is discipline, patience, and judgment.
• There are three central elements to a value-investment philosophy. First, value investing is a bottom-up strategy entailing the identification of specific undervalued investment opportunities. Second, value investing is absoluteperformance-, not relative-performance oriented. Finally, value investing is a risk-averse approach; attention is paid as much to what can go wrong (risk) as to what can go right (return).
• The entire strategy can be concisely described as “buy a bargain and wait.”
• In investing it is never wrong to change your mind. It is only wrong to change your mind and do nothing about it.
• Value investors, by contrast, are absolute-performance oriented; they are interested in returns only insofar as they relate to the achievement of their own investment goals, not how they compare with the way the overall market or other investors are faring.
• For most investors absolute returns are the only ones that really matter; you cannot, after all, spend relative performance.
• Absolute-performance-oriented investors, by contrast, are willing to hold cash reserves when no bargains are available. Cash is liquid and provides a modest, sometimes attractive nominal return, usually above the rate of inflation. The liquidity of cash affords flexibility, for it can quickly be channeled into other investment outlets with minimal transaction costs. Finally, unlike any other holding, cash does not involve any risk of incurring opportunity cost (losses from the inability to take advantage of future bargains) since it does not drop in value during market declines.
• While most other investors are preoccupied with how much money they can make and not at all with how much they may lose, value investors focus on risk as well as return.
• A positive correlation between risk and return would hold consistently only in an efficient market. Any disparities would be immediately corrected; this is what would make the market efficient. In inefficient markets it is possible to find investments offering high returns with low risk.
• Risk and return must instead be assessed independently for every investment.
• It is only when investors shun high-risk investments, thereby depressing their prices, that an incremental return can be earned which more than fully compensates for the risk incurred. By itself risk does not create incremental return; only price can accomplish that.
• Unlike return, however, risk is no more quantifiable at the end of an investment than it was at its beginning. Risk simply cannot be described by a single number.
• There are only a few things investors can do to counteract risk: diversify adequately, hedge when appropriate, and invest with a margin of safety.
• The reality is that past security price volatility does not reliably predict future investment performance (or even future volatility) and therefore is a poor measure of risk.
• The trick of successful investors is to sell when they want to, not when they have to. Investors who may need to sell should not own marketable securities other than U.S. Treasury bills.
• If what you hold is illiquid or unmarketable, the opportunity cost increases further; the illiquidity precludes your switching to better bargains.
• The most important determinant of whether investors will incur opportunity cost is whether or not part of their portfolios is held in cash. Maintaining moderate cash balances or owning securities that periodically throw off appreciable cash is likely to reduce the number of foregone opportunities.
• An added attraction of investing in riskarbitrage situations, bankruptcies, and liquidations is that not only is one’s initial investment returned to cash, one’s profits are as well. Another way to limit opportunity cost is through hedging. A hedge is an investment that is expected to move in a direction opposite that of another holding so as to cushion any price decline. If the hedge becomes valuable, it can be sold, providing funds to take advantage of newly created opportunities. (Hedging is discussed in greater depth in chapter 13.) Conclusion The primary goal of value investors is to avoid losing money. Three elements of a value-investment strategy make achievement of that goal possible. A bottom-up approach, searching for low-risk bargains one at a time through fundamental analysis, is the surest way I know to avoid losing money. An absolute-performance orientation
• The primary goal of value investors is to avoid losing money.
• Markets exist because of differences of opinion among investors.
• To be a value investor, you must buy at a discount from underlying value.
• While a great many methods of business valuation exist, there are only three that I find useful. The first is an analysis of going-concern value, known as net present value (NPV) analysis. NPV is the discounted value of all future cash flows that a business is expected to generate.
• The second method of business valuation analyzes liquidation value, the expected proceeds if a company were to be dismantled and the assets sold off.
• The third method of valuation, stock market value, is an estimate of the price at which a company, or its subsidiaries considered separately, would trade in the stock market. Less reliable than the other two, this method is only occasionally useful as a yardstick of value.
• How do value investors deal with the analytical necessity to predict the unpredictable? The only answer is conservatism. Since all projections are subject to error, optimistic ones tend to place investors on a precarious limb. Virtually everything must go right, or losses may be sustained. Conservative forecasts can be more easily met or even exceeded. 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 find 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 either holding cash or investing in short-term holdings that quickly return cash for possible redeployment when available returns are more attractive
• Calculating the present value of contractual interest and principal payments is the best way to value a bond. Analysis of the underlying business can then help
• analyzing the cash flows of the underlying business is the best way to value a stock.
• My personal rule is that investors should value businesses based on what they themselves, not others, would pay to own them.
• The liquidation value of a business is a conservative assessment of its worth in which only tangible assets are considered and intangibles, such as going-concern value, are not.
• when a stock is selling at a discount to liquidation value per share, a near rock-bottom appraisal, it is frequently an attractive investment.
• The assets of a company are typically worth more as part of a going concern than in liquidation, so liquidation value is generally a worst-case assessment.
• Even when a company has little ongoing business value, investors who buy at a price below net-net working capital are protected by the approximate liquidation value of current assets alone. As long as working capital is not overstated and operations are not rapidly consuming cash, a company could liquidate its assets, extinguish all its liabilities, and still distribute proceeds in excess of the market price to investors.
• value, investors who buy at a price below net-net working capital are protected by the approximate
• A corporate liquidation typically connotes business failure; but ironically, it may correspond with investment success. The reason is that the liquidation or breakup of a company is a catalyst for the realization of underlying business value. Since value investors attempt to buy securities trading at a considerable discount from the value of a business’s underlying assets, a liquidation is one way for investors to realize profits.
• Net present value would be most applicable, for example, in valuing a high-return business with stable cash flows such as a consumer-products company; its liquidation value would be far too low. Similarly, a business with regulated rates of return on assets such as a utility might best be valued using NPV analysis. Liquidation analysis is probably the most appropriate method for valuing an unprofitable business whose stock trades well below book value. A closed-end fund or other company that owns only marketable securities should be valued by the stock market method; no other makes sense.
• an analysis of cash flow would better capture the true economics of a business
• nonrecurring gains can boost earnings to unsustainable levels, and should be ignored by investors.
• an analysis of cash flow would better capture the true economics of a business. By contrast, nonrecurring gains can boost earnings to unsustainable levels, and should be ignored by investors.
• What something cost in the past is not necessarily a good measure of its value today.
• For every business that cannot be valued, there are many others that can. Investors who confine themselves to what they know, as difficult as that may be, have a considerable advantage over everyone else.
• the first and perhaps most important step in the investment process is knowing where to look for opportunities.
• Investors cannot assume that good ideas will come effortlessly from scanning the recommendations of Wall Street analysts, no matter how highly regarded, or from punching up computers, no matter how cleverly programmed, although both can sometimes indicate interesting places to hunt.
• By identifying where the most attractive opportunities are likely to arise before starting one’s quest for the exciting handful of specific investments, investors can spare themselves an often fruitless survey of the humdrum majority of available investments.
• Value investing encompasses a number of specialized investment niches that can be divided into three categories: securities selling at a discount to breakup or liquidation value, rate-of-return situations, and asset-conversion opportunities.
• A bargain should be inspected and re-inspected for possible flaws.
• Value investing by its very nature is contrarian
• Out-of-favor securities may be undervalued; popular securities almost never are. What the herd is buying is, by definition, in favor. Securities in favor have already been bid up in price on the basis of optimistic expectations and are unlikely to represent good value that has been overlooked.
• Since they are acting against the crowd, contrarians are almost always initially wrong and likely for a time to suffer paper losses. By contrast, members of the herd are nearly always right for a period.
• information generally follows the well-known 80/20 rule: the first 80 percent of the available information is gathered in the first 20 percent of the time spent. The value of in-depth fundamental analysis is subject to diminishing marginal returns.
• The time other investors spend delving into the last unanswered detail may cost them the chance to buy in at prices so low that they offer a margin of safety despite the incomplete information.
• the presence of a catalyst serves to reduce risk. If the gap between price and underlying value is likely to be closed quickly, the probability of losing money due to market fluctuations or adverse business developments is reduced.
• Companies get into financial trouble for at least one of three reasons: operating problems, legal problems, and/or financial problems.
• an investor’s portfolio management responsibilities include maintaining appropriate diversification, making hedging decisions, and managing portfolio cash flow and liquidity.
• All investors must come to terms with the relentless continuity of the investment process. Although specific investments have a beginning and an end, portfolio management goes on forever.
• Since no investor is infallible and no investment is perfect, there is considerable merit in being able to change one’s mind.
• When investors do not demand compensation for bearing illiquidity, they almost always come to regret it.
• Because the opportunity cost of illiquidity is high, no investment portfolio should be completely illiquid either. Most portfolios should maintain a balance, opting for greater illiquidity when the market compensates investors well for bearing it.
• When your portfolio is completely in cash, there is no risk of loss. There is also, however, no possibility of earning a high return.
• Investing is in some ways an endless process of managing liquidity.
• when the securities in a portfolio frequently turn into cash, the investor is constantly challenged to put that cash to work, seeking out the best values available.
• Even relatively safe investments entail some probability, however small, of downside risk. The deleterious effects of such improbable events can best be mitigated through prudent diversification. The number of securities that should be owned to reduce portfolio risk to an acceptable level is not great; as few as ten to fifteen different holdings usually suffice.
• The number of securities that should be owned to reduce portfolio risk to an acceptable level is not great; as few as ten to fifteen different holdings usually suffice.
• My view is that an investor is better off knowing a lot about a few investments than knowing only a little about each of a great many holdings.
• The fact is that a diverse portfolio of overpriced, subordinated securities, about each of which the investor knows relatively little, is highly risky.
• Diversification, after all, is not how many different things you own, but how different the things you do own are in the risks they entail.
• There is nothing inherent in a security or business that alone makes it an attractive investment. Investment opportunity is a function of price, which is established in the marketplace.
• The single most crucial factor in trading is developing the appropriate reaction to price fluctuations
• In my view, investors should usually refrain from purchasing a “full position” (the maximum dollar commitment they intend to make) in a given security all at once. Those who fail to heed this advice may be compelled to watch a subsequent price decline helplessly, with no buying power in reserve. Buying a partial position leaves reserves that permit investors to “average down,” lowering their average cost per share, if prices decline.
• there is only one valid rule for selling: all investments are for sale at the right price.
• Decisions to sell, like decisions to buy, must be based upon underlying business value.

Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor by Seth Klarman

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