The following is a line for line analysis of chapter two 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 or concept 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."
Chapter Two
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Wall Street is Plagued by Conflict of Interest
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“As Wall Street pursues its various activities, however, it frequently is plagued by conflicts of interest and a short-term orientation. Investors need not condemn Wall Street for this as long as they remain aware of it and act with cautious skepticism in any interactions they may have.” (page 20)
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It should be assumed that a conflict of interest is par for the course when crossing paths with Wall Street. Therefore, we needn’t be upset or worried when companies, acting in accordance with the goals of Wall Street, conduct business in a similar fashion. As investors we need to plan our strategies around the worst outcomes that have been the result of Wall Street “activities.”
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Wall Street Compensation
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“Wall Streeters get paid primarily for what they do, not how effectively they do it.” (page 20)
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Again, this extends to corporations that play the Wall Street game. If “The Street” feels that stock buybacks are an effective way to increase shareholder value then the corporations will do it. Although we have sat in on VC meetings where the head of a company explicitly said that share buyback are worthless as a strategy for increasing shareholder value.
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Create a New Product, Generate a Higher Fee
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“Sometimes the lust for underwriting fees drives Wall Street to actually create underwriting clients for the sole purpose of having securities to sell.” (page 22)
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The creation of ETFs, which were supposed to more effectively compete with Index Funds or supplant sector funds, seems to fit the bill in this regards since there is considerable question of whether the ETFs actually hold the asset they claim to be in possession of; either stock or commodities (article here). Now, with ETFs veering away from tracking indexes and sectors while allowing “fund managers,” we openly wonder what the difference between an ETF and the product it is supposed to replace. In our opinion, the primary difference, based on SEC filings on the matter, is collecting a fee without actual ownership of an asset. Thereby rendering the small “management fee” of an ETF into super profit in comparison to the traditional mutual fund and index fund.
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Buyer Gullibility is the Key
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“The periodic boom in closed-end mutual-fund issuance is a useful barometer of market sentiment; new issues abound when investors are optimistic and markets are rising. Wall Street firms after all do not force investors to buy these funds. They simply stand ready to issue a virtually limitless supply since the only real constraint is the gullibility of the buyers.” (page 24)
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Thankfully, none of the products that are consumed by the retail investor are done forcibly. However, this goes back to the idea that Klarman mentions about avoiding market fads in the introduction of his book…“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 (page xvii). All too often, investors ignore history which often reveals how easily a fad can take off. In the following quote, Klarman implies that a good rule of thumb on determining what a market fad is based on how long the product has been in existence, “Although newly issued junk bonds were a 1980s invention and were thus untested over a full economic cycle, they became widely accepted as a financial innovation of great importance…” (page 14). We would add to that rule of thumb by including that the more removed from actual ownership the less incentive there is to invest.
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Up Front Fees lead to Short-Term Focus
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“Brokers, traders, and investment bankers all find it hard to look beyond the next transaction when the current one is so lucrative regardless of merit.” (page 24)
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The concept of market share often leads to the belief that the other firm is going to eat your lunch. This ignores the fact that the other firm isn’t using a qualitative standard for entering into such transactions. This leads to all firms chasing any opportunity for a fee at the expense of the company, the industry and the customers.
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A Bullish Bias Forgets Risk
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“…with so much attention being paid to the upside, it is easy to lose sight of the risk.” (page 26)
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In our approach to any investment that is made, the priority is always on the likelihood of loss. The focus on loss requires the expectation that an investment will decline in value and having a reasonable strategy in place to deal with such scenarios before the investment is made. This makes our Investment Observations seem less enthusiastic as compared to someone who might think that a particular stock is reasonably undervalued.
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Declines must be orderly, increases can run amuk
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“Any downturn, according to the regulatory mentality [government regulators], should be free of panic. (Disorderly rising markets are of no evident concern)” (page 26).
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This is best demonstrated when circuit breakers were introduced for the New York Stock Exchange after the crash of 1987. In an ironic twist, circuit breakers were never triggered based on downside movement of the NYSE in the period from 2007 to 2009. So much for the effort to protect investors with circuit breakers. Another example of regulator bias against the downside is the requirement and/or effort to reintroduce the uptick rule for short sellers without a commensurate downtick rule for investors going long a stock.
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Undervalued conditions get resolved, Overvalued conditions can persist
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“Correcting a market overvaluation is more difficult than remedying an undervalued condition. With an undervalued stock, for example, a value investor can purchase more and more shares until control is achieved or, better still, until the entire company is owned at a bargain price. If the value assessment was accurate, this is an attractive outcome for the investor. By contrast, overvalued markets are not easily corrected; short selling, as mentioned earlier, is not an effective antidote. In addition, overvaluation is not always apparent to investors, analysts, or managements. Since security prices reflect investors’ perceptions of reality and not necessarily reality itself, overvaluation may persist for a long time”(page 28).
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This paragraph is the singular reason not to utilize the momentum investor’s approach of buying stocks that have made new highs. This is the method CNBC’s Cramer or Investor Business Daily’s William O’Neil tend to espouse. Whenever we seek out stocks at or near a new low, we’re trying to verify if the fundamentals of the company coincide with the price action of the stock.
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Always opt for the conservative estimate
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“The fad becomes dangerous, however, when share prices reach levels that are not supported by the conservatively appraised values of the underlying business” (page 34).
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In our opinion, conservative estimates, as they relate to a stock at a new 52-week high is always lower. For a stock within 10% or 15% of the high, the high is the upside limit with expectations of a downside target. For a stock at a new low, our conservative expectation is 10% to 15% higher with a target at the next lowest technical level. If the stock is 10% or 15% above the low then we conservatively expect a possible 10% increase with the downside at least to the new low level. The same could be said for expectations for any of the fundamental attributes of a company. However, we tend to use the next lowest full year figures available or worst case figures that are not in the negative. This is the way to conservatively consider the prospects of any company at the same time always mindful of the risk of loss regardless of our confidence in our conservatism.