Some weeks ago I finished the book 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 the final third Part of my Margin of Safety book-review covering value investment philosophy, though I finished the book some days ago. I can strongly recommend the book. If you are interested in value investing or want to improve on the topic then this book is worth your time!
In Part 3 Klarman lays out the most important aspects of a value investment process, such as investment research and portfolio management and trading.
As described in Part II, it is very important to know how to value a business as a value investor, it is vital to know where to look for investment opportunities in the first place. We, as value investors only have limited time so we want to spend our time researching investment ideas in the most promising hunting grounds.
- Lists of Shares with the worst performers might reveal an undervalued out-of-favor asset
- An elimination of its dividend often results in a stocks undervaluation (valuation anchor is missing)
Why is tha bargain available?
After finding a (perceived) bargain, it is important to think about why the bargain has become available. It should be inspected for possible flaws. are there fundamental reasons, you did not yet discover? After detecting the reason, the outcome of the investment is more predictable. Possible reasons could be institutional constrains, such as
- newly created spin-offs
- low institutional demand since not included in an index
- low-priced security
- small caps (closely held, infrequently traded, no analysts)
- selling driven by the calendar
- year end tax selling
- window dressing
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.Margin of Safety by Seth A. Klarman (1991), p.155
If value is not likely to exist in what the herd is buying, where may it exist? In what they are selling, unaware of, or ignoring. When the herd is selling a security, the market price may fall well beyond reason. Ignored, obscure, or newly created securities may similarly be or become undervalued. Investors may find it difficult to act as contrarians for they can never be certain whether or when they will be proven correct. Since they are acting against the crowd, contrarians are almost always initially wrong and likely for a time to suffer paper losses.
But, do not make a mistake on being contrarian! It is not an advantage per se!
Holding a contrary opinion is not always useful to investors, however. When widely held opinions have no influence on the issue at hand, nothing is gained by swimming against the tide. It is always the consensus that the sun will rise tomorrow, but this view does not influence the outcome. By contrast, when majority opinion does affect the outcome or the odds, contrary opinion can be put to use. When the herd rushes into home health-care stocks, bidding up prices and thereby lowering available returns, the majority has altered the risk/reward ratio, allowing contrarians to bet against the crowd with the odds skewed in their favor.Margin of Safety by Seth A. Klarman (1991), p.156
How much research?
Some investors or analysts want to get perfect knowledge of a company and its competitors before buying into it. This might make sense upon first sight and it’s surely admirable, but
- no matter how much effort and resources, some information will always be unknown, you have to live with uncertainty
- even if you had perfect knowledge of the fact, that is no guaranty for future profit.
Many analysts strive for certainty and precision, though, high returns are often provided where uncertainty is highest.
Insider buying might indeed be a signal that the stock is trading below fair value. After all, managers should have better insights than any analyst will ever have. There are many reasons for insider selling, but there are only so many reasons for insiders buying by their own choice.
Investment research is the process of reducing large piles of information to manageable ones, distilling the investment wheat from the chaff. There is, needless to say, a lot of chaff and very little wheat.Margin of Safety by Seth A. Klarman (1991), p.160
Profits may be realized only many years later. Often you find companies to be overvalued currently, if they will become undervalued in the future, there needs to be a buying decision and some catalyst for value realization down the road.
Areas of Opportunit
Unfortunately, ongoing, profitable, and growing businesses with share prices considerably below conservatively appraised underlying value are to be find rarely, since many investors are looking for such obvious investment opportunieties. Thus, value investors need to comprehend more compley situations. Ideally investments bring the opportunity for a catalyst for the realization for underlying value. Such catalysts could be
- orderly sale or liquidation of a business (total value realization)
- Corporate spinoffs
- share buybacks
- major asset sales
Buying assets at a discount is the defining characteristic for value investors, but mainly the catalists provide value realization and serve as a feature reducing risk.
Klarman discussed many other areas of opportuniy besides Spinoffs, but those are only of minor importance for me (risk arbitrage, complex securities, etc.).
The goal in spinning off such businesses is to create parts with a combined market value greater than the present whole.Margin of Safety by Seth A. Klarman (1991), p.178
There are many reasons why spinoffs can represent a great value proposition. Potential reasons could be
- the newly created company is too small (market cap)
- investors know too little about its business
- if not assigned to an index, index funds must sell it
- usually, analysts do not follow spinoffs
- the companies itself may even prefer to be temporarily undervalued for certain reasons, and thus may not report in the most positive way
- initially they may not be included in databases
Sometimes its a bargain to invest in the parent-company shares instead of in the spinoff.
Portfolio Management and Trading
Portfolio management encompasses trading activity as well as the regular review of one’s holdings. In addition, an investor’s portfolio management responsibilities include maintaining appropriate diversification, making hedging decisions, and managing portfolio cash flow and liquidity.Margin of Safety by Seth A. Klarman (1991), p.209
Specific investments might have a beginning and an end, but portfolio management goes on forever, investors must come to terms with its continuity.
Even if stocks represent fractional ownership of a business, the portfolio performance results from stock price performance which can be unattached from fundamental development of the comany for extended periods.
Importance of Liquidity
There is no need for an investment portfolio to offer complete liquidity. But a certain degree of liquidity is preferrable. Opting for greater illiquidity can be smart when the market is offering a premium for illiquidity bearers. The duration of an investment influences the degree of its liquidity a lot. But when investing in stocks, always remeber the warning of Louis Lowenstein about the liquidity illusion in stock markets
In the stock market, there is liquidity for the individual but not for the whole community. The distributable profits of a company are the only rewards for the community.
It is important to scan ones portfolio for dead wood.
Reducing Portfolio Risk
Executing a few great single investments in significantly undervalued securities is a very good start for most investors. But portfolio management goes beyond that, it is looking at the portfolio as a whole, especially paying attention to risk dimensions. Every investment should take risk into account as discussed in earlier chapters, but portfolio management takes into account the risk levels at the overall portfolio level.
Since the future is uncertain and even the highest quality companies could fail (though unlikely), diversification is an important measure to mitigate portfolio risk. Diversification is managing the relative size of single investments to the portfolio, mostly accomplished investing into 15 single securities. But, it’s not about the number of investments
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.Margin of Safety by Seth A. Klarman (1991), p.213
Investment opportunity is a function of price, which is established in the marketplace.Margin of Safety by Seth A. Klarman (1991), p.215
Trading is central to value investment since investors have to execute trades as the price is right to be successful. When other market participants act unwisely it creates opportunities for us value investors. That is the reason why it is important to stay in touch with the markets.
Being in touch with the markets can be dangerous and transform you in a short-term trader obsessed with the daily market moves. But trading per se does not provide value, the opposite is true, short-term trading is destroying value, it will cost you deerly.
Buying: Leave Room to Average Down
For value investors with regard to trading it’s of utmost importance to develop the appropriate reaction to price fluctuations. Value Investors must learn to resist their human emotions
- fear, the tendency to panic when prices are falling, and
- greed, the tendency to become overly enthusiastic when prices are rising.
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.Margin of Safety by Seth A. Klarman (1991), p.215ff
Evaluating your own willingness to average down can help you distinguish prospective investments from speculations. If the security you are considering is truly a good investment, not a speculation, you would certainly want to own more at lower prices. If, prior to purchase, you realize that you are unwilling to average down, then you probably should not make the purchase in the first place. Potential investments in companies that are poorly managed, highly leveraged, in unattractive businesses, or beyond understanding may be identified and rejected.Margin of Safety by Seth A. Klarman (1991), p.215ff
Selling: The Hardest Decision of All
Many investors are able to spot a bargain but have a harder time knowing when to sell. One reason is the difficulty of knowing precisely what an investment is worth. An investor buys with a range of value in mind at a price that provides a considerable margin of safety. As the market price appreciates, however, that safety margin decreases; the potential return diminishes and the downside risk increases. Not knowing the exact value of the investment, it is understandable that an investor cannot be as confident in the sell decision as he or she was in the purchase decision.Margin of Safety by Seth A. Klarman (1991), p.215ff
Buying and selling decisions must be based upon underlying business value, current price and alternative opportunities available. Trading and portfolio management techniques, sound buying and selling decisions and appropriate diversification are of importance to all investors. Of course, good portfolio management and trading are of maximum value when employed in conjunction with a value investment approach.
I risk to repeat myself, but: If you are either at the beginning of your (value) investing journey or interested in getting a deeper understanding of value investing philosophy, I can really recommend this book.
This three-part book-review-series helped me a lot on my perspective and deeper understanding of the topic of value investing. I will start a micro-page for value investing beside other concept pages based on these three posts and add relevant information in the future on an ongoing basis.
I really hope you liked my book-review and I am looking forward to receive some feedback or engage in discussions below.