The following is a line for line analysis of Seth Klarman's book Margin of Safety. we're providing the concept or idea that we think is being conveyed followed by the quote and page where you can find the citation. Additionally, we follow-up with our thoughts on the concept. We hope to review the complete book one chapter at a time.
According to GuruFocus.com, "Seth Klarman is a value investor and Portfolio Manager of the investment partnership The Baupost Group. Founded in 1983, The Baupost Group now manages $7 billion, and has averaged returns of nearly 20% annually since their inception. Seth Klarman is the author of the book "Margin of Safety" which sells for over $1000."
Introduction
- Where investors go wrong
- "Avoiding where others go wrong is an important step in achieving investment success. In fact, it almost ensures it.” p. xiii
- In order to know where investors go wrong a person must first determine where and when the biggest mistakes have been made. Examining history and market tops, along with subsequent declines, help an investor to see the errors that were made right before the errors were fully revealed. In addition, the best assessments of a market decline are done afterwards as well. Hence, books like Security Analysis that followed the Crash and Depression of 1929.
- "Avoiding where others go wrong is an important step in achieving investment success. In fact, it almost ensures it.” p. xiii
- Risk/Reward
- Before you can focus on the remote possibility of rewards the market has to offer, you must first focus on the probability of risk of loss. p.xiii
- No amount of stock market analysis is worth pursing if an assessment of loss, with the expectation of at least 50% loss, is not part of the equation.
- Before you can focus on the remote possibility of rewards the market has to offer, you must first focus on the probability of risk of loss. p.xiii
- Margin of Safety
- Value investors should always allow “…room for imprecision, bad luck, or analytical error in order to avoid sizable losses over time.” p.xiv
- Margin of safety means that the stock analyst expects to be wrong about their assessment and wouldn’t panic when the company that they’ve “invested” in doesn’t perform as planned.
- Value investors should always allow “…room for imprecision, bad luck, or analytical error in order to avoid sizable losses over time.” p.xiv
- The Ignorance of Indexing
- “…Indexing strategies [are] designed to avoid significant underperformance at the cost of assured mediocrity.” p. xv
- Being categorically against indexing of all sorts, either through ETFs, Index Funds or mutual funds, it is quite apropos that Klarman would say this.
- “…Indexing strategies [are] designed to avoid significant underperformance at the cost of assured mediocrity.” p. xv
- Know the Rationale of the Rules
- “…observing a few rules isn’t enough. Too many things change too quickly in the investment world for that approach to work [following some simple rules]. It is necessary instead to understand the rationale behind the rule in order to appreciate why they work when they do and don’t when they don’t.” Understanding the rationale behind the rules ensures success. p. xv
- In order to really understand the rule and the premise behind them an appreciation of history is required. Such an appreciation is not for the purpose of linking disparate events together. Instead, the purpose is to learn the underlying actions and reactions that create the market rules we’re forced to adhere to today.
- “…observing a few rules isn’t enough. Too many things change too quickly in the investment world for that approach to work [following some simple rules]. It is necessary instead to understand the rationale behind the rule in order to appreciate why they work when they do and don’t when they don’t.” Understanding the rationale behind the rules ensures success. p. xv
- Buy Low and a lot, Sell High and buy very little
- When prices are high risk very little capital, when prices are low risk a large amount of capital. p. xvi
- Our allocation model states that we only buy, at the most, 5 companies when fully invested. We only buy after reviewing stocks that have reached a new low and have been thoroughly assessed. We only target the companies that have increased their dividend every year for a minimum 10 years in a row or are quality companies that are a part of required mutual fund purchases, like Nasdaq 100 stocks.
- When prices are high risk very little capital, when prices are low risk a large amount of capital. p. xvi
- Avoid Market Fads (i.e. investment products)
- “The important point is not merely that junk bonds were flawed (although they certainly were) but that investors must learn from this very avoidable debacle to escape the next enticing market fad that will inevitably come along." Avoid market fads and fashions. p. xvii
- Yield chasing and investing out of convenience ultimately doesn’t end nicely. Right now the current fad is towards stocks and funds that pay high yields. Inevitably, Wall Street will provide or create products that meet the highest demand. This will result in exceptional yields with exceptional risk. Another market fad that has existed for a long time is the belief in mutual funds and related products (ETFs, index funds, etc). These are instruments of convenience that takes the investor away from learning as they invest. The cumulative effect is that those who participate in instruments of convenience don’t accrue the “true” knowledge necessary to succeed in investing which makes them ripe for falling for the latest fad.
- “The important point is not merely that junk bonds were flawed (although they certainly were) but that investors must learn from this very avoidable debacle to escape the next enticing market fad that will inevitably come along." Avoid market fads and fashions. p. xvii
- Speculation equals Opportunities
- Speculators “…actions often inadvertently result in the creation of opportunities for value investors.” p. xvii
- Speculators are often seen as the scrouges of the financial markets who create mayhem on whatever product they touch. However, successful speculators, of which there are few, usually quit while they’re ahead. Unsuccessful speculators, of which there are many, overreach and lose big or lose small frequently enough that the result is the same either way. The loses incurred by speculators ultimately result in the sale or disposition of assets at or below value. Value investors should be alarmed when they hear politicians clamoring for blood at the hands of speculators because many investment opportunities are created at the hands of willing sellers, typically speculators.
- Speculators “…actions often inadvertently result in the creation of opportunities for value investors.” p. xvii
- Rapid Rise and Fall
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The rapid rise and fall of prices on a daily basis cannot possibly reflect the change in earnings on a quarterly basis. p. xviii
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What seems most interesting is that some stocks fall in price as though there was a loss in quarterly earnings. A loss in earnings isn’t the same as earning less than expected. Some amusement is garnered from watching “investors” sell a stock simply because the company didn’t earn as much as expected. In certain instances, the rapid decline of a stock may present an opportunity to buy a stock at a reasonable price.
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