Recently I started to read Margin of Safety – Risk-Averse Value Investing Strategies for the Thoughtful Investor by Seth A. Klarman from 1991. Pretty much, one of the few must-reads about value investing.
This is only Part 2 (of 3) of my Margin of Safety book-review covering value investment philosophy, though I finished the book a few days ago. I can already tell you this: This book is worth your time!
Part 1 was about common mistakes of investors.
In Part 3 Klarman lays out the most important aspects of a value investment process.
Defining Your Investment Goals
In the beginning of the second section, Klarman argues that it is important to define your investment goals. He futher argues that defining “an investment goal of achieving a specific rate of return” is nonsense, instead he argues that
Investors should target risk.Margin of Safety by Seth A. Klarman (1991), p. 86
Klarman describes why the future returns of (safe) bonds are much more predictable than returns of stocks.
Stocks do not have the firm mathematical tether afforded by the contractual nature of the cash flows of a high-grade bond. Stocks, for example, have no maturity date or price. Moreover, while the value of a stock is ultimately tied to the performance of the underlying business, the potential profit from owning a stock is much more ambiguous. Specifically, the owner of a stock does not receive the cash flows from a business; he or she profits from appreciation in the share price, presumably as the market incorporates fundamental business developments into that price. Investors thus tend to predict their returns from investing in equities by predicting future stock prices. Since stock prices do not appreciate in a predictable fashion but fluctuate unevenly over time, almost any forecast can be made and justified. […]Margin of Safety by Seth A. Klarman (1991), p. 85
In the long run, however, stock prices are also tethered, albeit more loosely than bonds, to the performance of the underlying businesses. If the prevailing stock price is not warranted by underlying value, it will eventually fall. Those who bought in at a price that itself reflected overly optimistic assumptions will incur losses.
The Importance of a Margin of Safety
The essence of value investing is to buy securities at a significant discount to their current underlying fair value and hold them until this gap has narrowed. This is often described as buying the dollar for fifty cents. (Ideally the dollar will increase its future value)
Only to buy those securities which are to be had at a significant discount makes value investing very much a risk-averse approach. Additionally it is required, only to invest in understandable and not too risky companies as well as only to act on the best opportunities (relative to other discounted securities) or to say waiting for the right pitch. Maintaining this discipline is harder than it sounds. Often value investors are against the (investment) crowd or the market and are indeed contrarians.
Margin of Safety
Valueing businesses is very complex and there are a lot of variables involved. Thus the estimated fair value of the business is only a buest guess and is never certain. It is impossible to know all relevant facts and they can change every single day. At the end of the day, you could be wrong with the estimated fair value.
Because of this uncertainty involved, it is very important to be aware of that involved uncertainty. The true fair value could be higher or lower than estimated. According to B. Graham, when buying assets at a discount to the estimated but uncertain underlying value you get a Margin of Safety which allows for various sorts of getting things wrong, such as “human error, bad luck, or extreme volatility in a complex, unpredictable, and rapidly changing world“.
It’s also important why you are able to buy an assets at a discount and to check after the purchase is made if this reason for buying still persists. Additionally, its important to acknoledge, that value investing (sometimes) works best in a declining stock market (the rising tide lifts all most ships).
Value Investing vs Modern Financial Theory
Each and every finance student will have heard about the efficient-market hypothesis which basically states that all securities are fairly priced.
Value investing is, in effect, predicated on the proposition that the efficient-market hypothesis is frequently wrong.Margin of Safety by Seth A. Klarman (1991), p. 98
Klarman points to the fact, that “large cap stocks tends to be more efficient than that of small cap stocks, (…) and other less-popular investment fare”.
Klarman concludes the following in chapter 6
Value investing is simple to understand but difficult to implement. Value investors are not supersophisticated analytical wizards who create and apply intricate computer models to find attractive opportunities or assess underlying value. The hard part is discipline, patience, and judgment. Investors need…
- Discipline to avoid the many unattractive pitches that are thrown
- Patience to wait for the right pitch
- Judgment to know when it is time to swing
At the Root of a Value-Investment Philosophy
Klarman recommends to do bottom-up investing. Meaning always analyse specific companies instead of buying into a certain industry or region based on some macro economic notion or perceived trends in consumer behavior.
Strive for an absolute-performance orientation. Do not fall for the relative performance compared to other investors (this is mostly tha game of institutional investors). “You cannot, after all, spend relative performance.”
Value investors care about risk and return. It’s important to understand that risk is not volatility of the daily quoted Price per Share.
Risk and return must instead be assessed independently for every investment. In point of fact, greater risk does not guarantee greater return. To the contrary, risk erodes return by causing losses. 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.Margin of Safety by Seth A. Klarman (1991), p.111
The Nature of Risk
The risk of an investment is described by both the probability and the potential amount of loss. The risk of an investment — the probability of an adverse outcome — is partly inherent in its very nature. A dollar spent on biotechnology research is a riskier investment than a dollar used to purchase utility equipment. The former has both a greater probability of loss and a greater percentage of the investment at stake.Margin of Safety by Seth A. Klarman (1991), p.111
Risk also depends on the price paid. Everything else equal, it is obviously less risky to buy stock A at 50 dollars, than to buy it at 100 dollars.
Every investment decision involves certain risks, of which some might be obvious, others are not. To counteract risk investors should diversify adequately.
For Beta or Worse
Within Modern Financial Theory and Capital Asset Pricing Model or CAPM risk is quantified as a single statistical measure called Beta (β).
Funny fact: The picture above with the two formulas is actually from my proprietary formulary from the good old times as a student in cologne 😀
( If you are not familiar with CAPM and you want to make sense of this section and the context: pls see wiki )
According to Klarman, Beta (β) is useless as a gauge of risk involved with any security or certain stock as used in the CAPM framework. Beta assigns a risk to a stock depending on its historic price developments in conjunction with a (market) index. The riskiness of a stock is not dependent on its short-term price fluctuations but on the probability and (weighted) magnitude of loosing capital (permanent loss of attached to an investmentvalueunderlying value) permanently.
The Art of Business Valuation
Business valuation is imprecise. It is just impossible to pin an exact value to your home, so why should it ever be possible to exactly value a business, which is way more complex than a house.
Earnings per Share or Earnings Growth, Dividend Yield as well as Book Value do have a place in securities analysis but must be used with caution and as part of a more comprehensive valuation effort. There are just too many moving and uncertain parts involved
- Micro- and macro factors
- market factors
- many inputs with interconnectedness somewhat uncertain
Any attempt to value businesses with precision will yield values that are precisely inaccurate.Margin of Safety by Seth A. Klarman (1991), p.118
You should also be wary of methodically highly sophisticated models, because the chance is that the modeler delved right into the conceptual engineering part (methods) without wasting much time on thinking about the inputs (assumptions). Always remember: Garbage in, garbage out!
A Range of Value
Bonds can be valued rather straight forward, basically the bonds current price is the value of its discounted contractual cash flows (interest + pricipal repayment). The discount rate is calculated as risk free rate (per maturity) + risk spread, depending on the default risk (and some other things).
Opposed to that, equity securities are much harder to value, since:
- Stocks to not entitle the owner to contractual cash flows (like a bond)
- Equity securitites represent fractional ownership of a business. Earnings/cash flows of this business can either
- be reinvested (cash outflows)
- stay in the business (cash and equivalents at a banking account), or be
- payed to owners as dividends
- The business’ earnings or cash flows are again dependable on so many factors (some of them might be very important, some less so), that it is impossible to estimate each factor and its effect on earnings with precision.
The essential point is: You not not have to determine exactly what’s the intrinsic value of a business. it is enough to come to the conclusion, that the intrinsic value of a business is considerably higher than current market value.
If expert analysts with extensive information cannot gauge the value of high-profile, well-regarded businesses with more certainty than this, investors should not fool themselves into believing they are capable of greater precision when buying marketable securities based only on limited, publicly available information.
Markets exist because of differences of opinion among investors. If securities could be valued precisely, there would be many fewer differences of opinion; market prices would fluctuate less frequently, and trading activity would diminish.
To be a value investor, you must buy at a discount from underlying value. Analyzing each potential value investment opportunity therefore begins with an assessment of business value, using one of these three methods:
- Going-concern Net Present Value (NPV) Analysis, basically DCF
- Liquidation Value
- Stock market value
Present Value Analysis and the Difficulty of Forecasting Future Cash Flows
Usual problems with the NPV are (i) future cash flows are quite uncertain and (ii) the choice of discount rate can be arbitrary. Far more things can go wrong than things that can go right.
Even byuing good businesses is not always a good buying decision, since:
For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developmentsMargin of Safety by Seth A. Klarman (1991), p.124
There is only one answer to all these (and more) risks and uncertainties: conservatism.
The Choice of a Discount Rate
There is no single correct discount rate (sorrry it’s not always 10%). Things to be considered when approximating a realistic and conservative discount rate:
- personal preference for present over future consumption (cash flows)
- investor’s risk profile
- return for alternative investments
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 availableMargin of Safety by Seth A. Klarman (1991), p.127
(Chapters not discussed here: Private-Market Value, Liquidation Value and Stock Market Value, and more)
Conventional Valuation Yardsticks
Earnings (per Share), Book Value and dividend yield have there a place in securitties analysis, but they must be used with caution and should only be part of a more comprehensive analysis of underlying value.
In conclusion, Business valuation is a complex process yielding imprecise and uncertain results. Indeed, many businesses are so complex or difficult to understand that they simply cannot be valued. Investors must remember they do not need to swing at every pitch to do well over time!
I hope you enjoyed the post. Part three will follow.