Yet someone who buys long-term securities intending to quickly resell ra ther than hold is a speculator, an d thi rty-year Treasury bonds hav e also effectively become trad ing sardines.
We can all wo nder wha t wo uld happen if the thirty-year Treasury bond fell from favor as a speculative vehicle, causing these short-term holders to ru sh to sell at once and turning thirty-year Treasury bonds back into eati ng sardines. Investment s and Sp ecul ations ust as finan cial-market participa nts can be d ivided into two goups, investors and speculators, asse ts an d secu rities can. The distinction is not clear to most people. Both investm ents and speculations can be bought and sold.
Both typ ically fluctua te in price and can thus appear to genera te investment returns. But there is one critical difference: investments throw off cash flow for the benefit of the owners; speculations do no t. The greedy tendency to want to own anything that has recently been rising in price lures many people into purchasing specu lations.
Stocks and bonds go up and down in price, as do Monets and Mickey Man tIe rookie card s, but there should be no confusion as to which are the true investments. Collectibles, such as art, antiques, rare coins, and baseball cards, are not investments, but rank speculations. This may not be of consequence to the Cha se Manhattan Bank, which in the late s formed a fund for its clients to invest in art, or to David L. Even Wall Street, wh ich knows be tter, chooses at times to blur the distinction.
Salomon Brothers, for example, now publishes the rate of retu rn on various asset classes, including in the same list U. Treasury bills, stocks, impressionist and old master paintings, and Chinese ceramics. Investments, even very long-term inves tments like newly planted timber pro perties, 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.
By cont rast, collectibles throw off no cash flow; the only cash they can generate is from their eventual sale. The future buyer is likewise dependent on his or her own prospects for resale. The val ue of collectibles, therefore, fluctuates solely with supply and demand. Collectibles have no t histo rically been recog-.
The apparent value of collectibles is based on circular reasoning: people buy because others have recently bought. This has the effect of bidding up prices, which attracts publicity and creates the illusion of attractive returns.
Such logic can fail at any time. Investment success requires an appropriate mind-set. Investing is serious business, not entertainment. If you participate in the financial markets at all, it is crucial to do so as an investor, not as a speculator, and to be certain that you understand the difference.
Needless to say, investors are able to distinguish Pepsico from Picasso and understand the difference between an investmen t and a collectible. When your hard-earned savings and future financial security are at stake, the cost of not distinguishing is unacceptably high.
The Differences between Successful and Unsuccessful Investors Successful investors tend to be unemotional, allowing the greed an d fear of others to play into their hands. By having confidence in their own analysis and judgment, they respond to market forces not with blind emotion but with calculated reason. Successful investors, for example, demonstrate caution in frothy ma rkets and steadfast conviction in panicky ones.
Taking Advantage of Mr. Market I wrote earlier that financial-market participants must choose between investment and speculation. Those who Wisely choose investment are faced with another choice, this time rerween two opposing views of the financial markets. One -iew; widely held among academics and increasingly among.
Matching the market return is the best you can hope for. Those who attempt to outperform the market will incur high transaction costs and taxes, causing them to underperfonn instead.
The other view is that some securities are inefficiently priced, creating opportunities for investors to profit with low risk. This view was perhaps best expressed by Benjamin Graham, who posited the existence of a Mr. Market stands ready every business day to buy or sell a vast array of securities in virtually limitless quantities at prices that he sets. He provides this valuable ser vice free of charge. Sometimes Mr. Market sets prices at levels where you would neither want to buy nor sell.
Frequently, however, he becomes irrational. Sometimes he is optimistic and will pay far more than securities are worth. Other time s he is pessimistic, offering to sell securities for considerably less than underlying va lue. Value investorS-who buy at a disc ount from underlying value-c-are in a position to take advantage of Mr. Some investors-really speculators-mistakenly look to Mr.
Market for investment guidance. They observe him setting a lower price for a security and, unmindful of his irrationality, rush to sell their holdings, ignoring their own assessment of underlying value. Other times they see him raising prices and, trusting his lead, buy in at the higher figure as if he knew more than they. The reality is that Mr. Market knows nothing, being the product of the collective action of thousands of buyers and sellers who themselves are not always motivated by investment fundamentals.
Emotional investors and speculators inevitably lose money; investors who take advantage of Mr. For a recent purchase deci sion rising prices provide positive reinforcement; falling prices, negative reinforcement. If you buy a stock that subsequently rises in price, it is easy to allow the positive feedback provided. Market to influence your judgment. You may start to believe that the security is worth more than you previously thought and refrain from selling, effectively placing the judgment of Mr.
Market above your own. You may even decide to buy more shares of this stock, anticipating Mr. As long as the price appears to be rising, you may choose to hold, perhaps even ignoring deteriorating business fundamentals or a diminution in underlying value. Similarly, when the pri ce of a stock declines after its initial purchase, most investors, somewhat naturally, become concerned.
They start to worry that Mr. Market may know more than they do or that their original assessment was in error. It is easy to panic and sell a t just the wrong time. Yet if the security were truly a bargain when it was pu rchased, the rational course of action would be to take advantage of this even be tter bargain and bu y more. Louis Lowenstein has warned us not to confuse the real success of an investment with its mirror of success in the stock market.
Likewise, a price fall in and of itself do es not necessarily reflect adverse bu siness developments or value deterioration. It is vitally important for investors to d istingui sh stock price fluctuations from underlying bu siness reality. If the general tendency is for bu ying to beget more bu ying and selling to precipitate more selling, investors must fight the tendency to capitulate to market forces. You cannot ign ore the ma rket- ignoring a sou rce of inves tment opportunities wo uld obvious ly be a mistake-bu t you must think for yourself and not allow the market to direct you.
Value in relation to price, not p rice alone, must determine your investm ent decisions. If you look to Mr. Market as a creator of investment opp ortunities where price departs from underlying value , you have the makings of a value investor.
If you insist on lookin g to Mr. Market for investment guidance, however, you are probably best advised to hire someone else to manage your money. Security prices move up and down for two basic reas ons: to. Reality can change in a number of ways, some company-specific, others macroeconomic in nature. When the shares of Fund American Companies, Inc. On a macroeconomic level a broad-based decline in interest rates, a drop in corporate tax rates, or a rise in the expected rate of economic growth could each precipitate a general increase in security prices.
Security prices sometimes fluctua te, not based on any apparent changes in reality, bu t on changes in investor percep tion. The shares of many biotechnology companies doubled and tripled in the first months of 1 9 9 1, for example desp ite a lack of change in company or industry fundamentals that could pcssibly have explained that magnitude of increase. The only explanation for the price rise was that investors were suddenly willing to pay much more than before to buy the same thing.
In the short run supply and demand alone determine market prices. If there are many large sellers and few buyers, prices fall, sometimes beyond reason. Supply-and-demand imbalances can result from year-end tax selling, an institutional stampede out of a stock that just reported disappointing earnings, or an unpleasant ru mor. Most day-to-day market price fluctuations result from supply-and-demand variations rather than from fundamental developments.
Investors will frequently not know why security prices fluctuate. They may change because of, in the absence of, or in complete indifference to changes in underlying value.
In the short run investor perception may be as important as reality itself in. Because security prices can change for a Rather than respond ing coolly and rationally to market fluctuations, they respond emotionally with greed and fear. We all know people ho act respon sibly and deliberately most of the time but go berserk when investing money.
The same people would read several consumer publications and visit numerous res before purchasing a stereo or camera yet spend little or no ecie investigating the stock they just heard about from a friend. Many unsuccessful investors regard the stock market as a 2. Anyone would - y a quick and easy profit.
Greed lead s many investors to seek shortcuts to investment success. Rather than allowing rums to compound over time, they attempt to tum quick fits by acting on hot tips. They d o not stop to consider how tips ter could possibly be in possession of valuable informathat is not illegally obtained or why, if it is so valuable, it is - g made available to them. Greed also manifests itself as sdue op timism or, more subtly, as complacency in the face of. Finally greed can cause investors to shift their focus away from the achievement of long-term investment goals in favor of short-term speculation.
High levels of greed sometimes cause new-era thinking to be introduced by market participants to justify buying or holding overvalued securities. Reasons are given as to why this time is different from anything that came before.
As the truth is stretched, investor behavior is carried to an extreme. Conservative assumptions are revisited and revised in order to justify ever higher prices, and a mania can ensue.
In the short run resisting the mania is not only psychologically bu t also financially difficult as the participants make a lot of money, at least on paper.
Then, predictab ly, the mania reaches a peak, is recognized for what it is, reverses course, and turns into a selling panic. Greed gives way to fear, and investor losses can be enormous. As I discuss later in detail, junk bonds were definitely such a mania. Buyers greedily departed from his torica l standards of business valuation and creditworthiness. Even after the bubble burst, many proponents stubbornly clung to the validity of the concep t.
Greed and the Yield Pigs of the s There are countless examples of investor greed in recent financial history. Doub le-digit interest rates on U. When interest rates declined to sing le digits, many investors remained infa tuated with the attainment of higher yields and sacrificed credit quality to achieve them either in the bond market or in equities. Wall Street responded with gusto, as Wall Street tends do when there are fees to earn, creating a variety of instrumen ts that promised high current yields.
Ic achieve current cash yields appreciably above those availIe from U. Low-grade securities, such as junk bonds, offer higher yields than govema.
Junk-bond mutual unds were marketed to investors in the s primarily ugh the promise of high current yield. Junk bonds were not the only slop served up to the yield pigs the s. Every month owners of GNMAs receive distri. The principal portion includes contractual payililents as well as voluntary prepayments. Many holders tend to of the yield on GNMAs in terms of the total monthly disution received.
The true economic yield is, in fact, only the! The principal component of the monthly distributions is a yield on capital, but a return of capital. Thus investors who A call option is the right to buy a security at a specified price during a stated period of time. This total cash distribution is touted as the current yield to investors. When covered call options written against the portfolio are exercised, however, the writer forgoes appreciation on the securities that are called away.
The upside potential on the underlying investments is truncated by the sale of the call options, while the downside risk remains intact. This strategy places investors in the position of uninsured homeowners, who benefit currently from the small premium not paid to the insurance company while remaining exposed to large future losses. As long as security prices continue to fluctuate both up and down, writers of covered calls are certain to experience capital losses ove r time, with no possible offsetting capital gains.
In effect, these funds are eating into principal while misleadingly reporting the principal erosion as yield. Some investors, fixated on current return, reach for yield not with a new Wall Street product, but a very old one: common stocks.
Finding bond yields unacceptably low, they pour money in to stocks a t the worst imaginable times. These investors fail to consider that bond market yields are public information, well known to stock investors who incorporate the current level of interest rates into share prices.
When bond yields are low, share prices are likely to be high. Yield-seeking investors who rush into stocks when yields are low not only fail to achieve a free lunch, they also tend to buy in at or near a market top. It is human nature to seek simple. Given the complexithe investment process, it is perhaps natural for people to that only a formula could lead to investment success. The idea is - ::l: paying a low multiple of earnings, an investor is buying ut-of-favor bargain.
In reality investors who follow such a Investors who buy such stocks may soon find - :. The - recovery after the October stock market shakeout and unk-bond market collapse provide reinforcement of this. The quest for u. Inves tors would be much better off to redirect the time and effort committed to devising form ulas into fundamental analysis of specific investment opportunities. Conclusion The financial markets offer many temp tations to vu lnerable investors.
It is easy to do the wrong thing, to speculate rather than invest. Emotion lies dangerously close to the surface for mos t investors and can be particularly intense when market prices move drama tically in either direction. It is crucial that investors understand the difference between speculating and investing and learn to take advantage of the opportunities presented by Mr.
Noles 1. Sequoia Fund, Inc. William A. Sahlman and Howard H. Other precious metals and gems have a less-established value than gold but might be considered by some to be a similar type of holding.
Benjamin Graham, The Intelligent Investor, 4th ed. The sad truth is, however, that many investors Me no t well served in their dealings with Wall Stree t; they uld benefit from developing a greater understanding of the oay Wall Street works.
The prob lem is that what is good for. IIStreet is not necessarily good for investors, and vice versa. Wall Street has three principal activities: trading, investment enking, and merchant banking. As investment bankers they iIrrallge for the purchase and sale of entire companies by others, derw rite ne w securities, prov ide financia l ad vice, and opine the fairness of specific transactions.
As merchant bankers. As Wall Stree t pursu es its various activities, however, it frequently is plagued by conflicts of interest and a short-term orientat ion. Investors need not condemn Wall Street for this as long as they remain aware of it and act with cautious skepticism in any intera ctions they may have. Brokerage commissions are collected on each trade, regardless of the outcome for the investor.
Investment banking and underw riting fees are also collected up front, long before the ultimate success or failure of the transaction is known.
All investors are awa re of the conflict of interest facing stockbrokers. While their customers might be best off owning minimal commission U.
Treasury bills or commission-free no-load mutual funds, brokers are financially motivated to sell high-commission securities. Brokers also have an incentive to do excessive short-term trading known as churning on behalf of discretionary customer accounts in which the broker has discretion to transact and to encourage such activity in nond iscretionary accounts. A significant conflict of interest also arises in securities underwriting. This function involves raising money for corporate clients by selling new ly issued securities to customers.
Need less to say, large fees may motivate a firm to underw rite either overpriced or highly risky securities and to favor the limited number of underwriting clients over the many small buyers of those securities.
In merchant banking the conflict is more blatant still. Doctors, lawyers, accountants, and other fessionals are paid this way; their compensation does not oend on the ultimate outcome of their services. The point I making is that investors should be aware of the motivations e people they transact business with; up-front fees clearly a re a bias toward frequent, and not necessarily profitable, actions. These sha red with stockbrokers who sell the underwritten securiro clients. By contrast, the commissions earned by brokers on secry-market transactions, which involve the resale of securifrom one investor to another, are much smaller.
Large Small individual investors are G ly charged considerably more. The higher commission on new underwritings provides a strong incentive to stockbrokers to sell them to clients.
The strong financial incentive of brokers touting new security underwritings is not the only cause for investor concern. The motivation of the issuer of securities is also suspect and m ust be thoroughly investigated by the buyer.
Gone are the days if they ever existed when a new issue was a collaborative effort in which a business that was long on prospects bu t short on capital could meet investors with capital in hand but with few good outlets for it.
Today the initial public offering market is where hopes and dreams are capitalized at high multiples. Investors even remotely tempted to buy new issues must ask themselves how they cou ld possibly fare well when a savvy issuer and greedy underwriter are on the opposite side of every underwriting.
Indeed, how attractive could any secu rity underwriting ever be when the issuer and underwriter have superior information as well as control over the timing, pricing, and stock or bond allocation? The deck is almost always stacked against the buyers. Sometimes the lust for underwriting fees drives Wall Street to actually create underwriting clients for the sale purpose of having securities to sell. Most closed-end mutual funds, for example, are formed almost exclusively to generate commissions for stockbrokers and fees for investment managers.
There was a story a few years ago that an announcement to the sales force of a prestigious Wall Street underwriting firm regarding the formation of a closed-end bond fund was met with a standing ovation.
The clients could have purchased the same securities much less expensively on a direct basis, but in the form of a closed-end fund the brokers stood to make many times more in commissions.
Within months of uance, closed-end funds typically decline in price below the. This means that purchasers of closedfunds on the initial public offering frequently incur a quick -- of 10 to 15 percent of their investment. The boom in the creation of new closed-end country exemplifies the tension between Wall Street and its cusers.
As noted in chapter I, speculative interest in closed-end try funds resulted in the shares of many funds being bid above underlying NAVs. Buying into new offerings red to be a quick, easy, and almost certain way to make. In June , for example, the Spain Fund, Inc.
Funds were formed to invest in such exotic locales as rria, Brazil, Ireland, Thailand, and Turkey. Ironically, only after the boom in issuance of closed-end country funds Iraq invaded Kuwait. The prospect of finding new buyers who would pay.
As a resul t. The periodic boom in closed-end mutual-fund issuance is a useful barometer of market sentiment; new issues abound wh en 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.
Brokers, traders, and investment bankers all find it hard to look beyond the next transaction when the cu rrent one is so lucrative regardless of merit. This was even more applicable than usual in the late s and early s, a timewhen fees were enormous and when most Wall Streeters felt less than secure abou t the permanence of their jobs, and even their careers, in the securities industry. Wall Street collected inves-tment banking and underwriting fees when those companieswere acquired in highly leveraged junk-band-financed takeovers and collected large fees again when the debt was replaced with newly underwritten equity.
Some people work on Wall Street solely to earn high incomes, expecting to depart after a few years. Others, do ubting their -n ultimate success, perhaps justifiably, are unwilling to rego short-term compensation for long-term income that may -er arrive.
Notwithstanding, a minority of peo ple on Wall Street have caaintained a long-term perspective. A few Wall Street partnernips have done a particularly good job of motivating the ir employees to think past the current transaction.
Many Wall Stree ters, especially stockbrokers, ha ve come to Iieve that their clien ts will normally leave the m after a coup le. There are no sure things on Wall Seeet, and even the best-intentioned and most insightful advice y not work out. It is true tha t clien ts who incur losses may itch brokers. This does not excuse those who assume that t tu rnover is the norm and thus seek to max imize commis5JOfLS and fees over the short term, making client tu rnover a self-ful fillin g p rophecy.
Wall Street firms can Brokers, likewise, do more business and have happier cusers in a rising market. Even securities held in inventory to. Iben a Wall Street analyst or broker expresses op timism, resters must take it with a grain of salt. The bullish bias of Wall Street man ifests itself in many ways. Wall Stree t research is strongly oriented toward buy rather than sell recommenda tions, for example.
Perhaps this is the case because anyone with money is a candida te to buy a stock or bond, whi le only those who own are cand ida tes to sell.
In other words, there is more brokerage business to be done by issuing an op timistic research report than by writing a pessimistic one. In addition, Wall Street analysts are un likely to issue sell recommendations due to an understandable reluctance to say negative things, however tru thful they may be, about the companies they follow.
This is especially true when these companies are corporate-finance clien ts of the firm. It is easy for Wall Streeters to be bullish. A few optimistic assumptions will enable a reasonable investment case to be ma de for practically any stock or bond. The prob lem is ilia: with so much attention being paid to the upside, it is easy to lose sight of the risk. Investors naturalf prefer rising secur ity pr ices to falling ones, profits to losses.
It is more pleasant to contemplate upside po tential than downside risk. Rising markets are accompanied by investor confidence, which the regulators desire to maintain. Any downturn, according to the regulatory mentality should be orderly and free of pa nic. Disorderly rising mar kets. Accordingly, market regulators have devised certain stock market rules that have the effect of exacerbating the upward bias of Wall Streeters. First, many institutions, including all mutual funds, are prohibited from selling stocks or bonds short.
A short sale involves selling borrowed stocks or bonds; it is the opposite of the traditional investment strategy of buying a security, otherwise known as going long. The combination of rest rictive short-sale rules and the limited um ber of investors who are both willing and able to accept the unlimited downside risk of short-selling increases the likelid that security prices may become overvalued. Short-sellers, who might otherwise step in to correct an overvaluation, are sew in number and significantly constrained.
These included restrictions on the price movement of ks and index futures and on program trading. If stocks fall another points after trading resumes, will be an additional two-hour halt.
Although high stock prices cannot be legislated some-e tha t many on Wall Street may secretly wish , regulation cause overvalua tion to persist by making it easier to occur more difficult to correct. The upward bias of market regula-. Many of the same factors that contribute to a bullish bias can cause the financial markets, especially the stock market, to become and remain overvalued. Correcting a market overvaluation is more d ifficult than remedying an undervalued condition, With an undervalued stock, for example, a value investor can purchase more and more shares un til control is achieved or, better still, until the entire company is owned at a ba rgain pr ice.
It the value assessment was accura te, this is an attractive outcome for the investor. By contrast, overvalued markets are not easily corrected; shor t-selling, as mentioned earl ier, is no t an effective antido te. In addition, overvaluation is not always apparent to investors, ana lysts, or managements. Occasiona lly sud: offerings bo th solve the financ ial problems of issuers and meet the needs of investors. In most cases, however, they address only the needs of Wall Street, tha t is, the generation of fees anc commissions.
Wall Street earns fees and commissions with no risk; institutional inves tors may be able at tract more money to manage by creating new vehicles invest in the innovative securities. The buy side and sell side in effect become co-conspirators, each having a vested interest in the contin ued success of the innovation. Any long-term benefit to the issuers or actual owners of the new securities is considerably less certain.
In the s the financial markets were flooded with new varie ties of debt and derivative securities. Some of these securi ties, such as auction-rate preferred-stock and zero-coup on bonds, have been discredited by events. Investors must recognize that the early success of an innovabL1n is not a reliable indicator of its ultimate merit. Both buyers ii:id sellers must believe that they will benefit in the short run, the innovation will not get off the drawing board; the longerterm consequences of su ch innovations, however, ma y not have considered carefully.
At the time of issuance a new type of security will appear to add valu e in the sam e way that a new isumer product does. What ap pears to be new and roved today may pro ve to be flawed or even fallaciou s. If one d successfully completed, Wall Street sees this as a sure sign still another deal can be done, In virtually all financial inn tions and investment fad s, Wall Street creates additional su until it equals an d then exceeds market demand.
The p motivation of Wall Street firms and the intense compe. The eventual market saturation of Wall Street fads coin. When a particular is in vogue, success is a self-fulfilling prophecy. As buyers up p rices, they help to justify their original enthusiasm.
A conventional mortgage-backed security fluctuates in. First, the va lue mortgage declines as interest rates rise because, as w it in teres t-bearing security, it is worth less when its periodic flows are discounted at the new, higher ra te.
The responses of separate las and pas to interest changes are ve ry differen t from those of an intact mort -. The reais, if interest rates rise, interest payments on an 10 will be ived for a longer period. Experience shows that the present e of a larger number of payments is more than that of a lier number of payments, even at a somewhat higher dist rate.
Because of this counterfluctuation, such mortgage - tors as thrifts and insurance companies are attracted to lOs a potential hedge against changes in interest rates. The price s, conversely, moves in the same direction as conventional r gages in response to interest rate changes but with greater ility, Thus they are potentially useful instruments for anyw ish ing to speculate on interest rates.
The question, as with any - cial-m arket innovation, is whether anyone else was better especially after allowing for the commissions, fees, and er markups.
The buyers, frequently thrifts and insurance anies, were betting on their own ability to understand a new security.
They needed to understand it better than market participants, and at least as well as Wall Street, to being exploited. They depended on the emergence of a ined, liquid market for the securities they bought.
What if accurate and timely What if interest rate fluctuations rendered each of securities more volatile than expected? Click Download or Read Online button to get margin-of-safety-pdf book now. This site is like a library, Use search box in the widget to get ebook that you want. For those who do not have the 00 for the book, check this out. There is a scanned. I still cannot believe this is out of print…. Click Download or Read Online button to get margin-of-safety book now. Find great deals on eBay for seth klarman margin of safety.
Shop with confidence. By diversifying your holdings, you can reduce the impact that one bad stock pick has on your portfolio. Rather than causing significant permanent loss, your loss is mitigated to a much smaller percentage of your portfolio. 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. Klarman favours a much more concentrated portfolio than that. This moderate level of diversification has another key advantage, too. Like Buffett, Seth Klarman also favours concentrating on your top picks. One's very best ideas are likely to generate higher returns for a given level of risk than one's hundredth or thousandth best idea.
Instead, Klarman favours diversifying not only in terms of the number of stocks in your portfolio but also among the sort of risks you take on. Junk-bond-market experts have argued vociferously that a diversified portfolio of junk bonds carries little risk. Investors who believed them substituted diversity for analysis and, what's worse, for judgment. The fact is that a diverse portfolio of overpriced, subordinated securities, about each of which the investor knows relatively little, is highly risky.
Diversification of junk-bond holdings among several industries did not protect investors from a broad economic downturn or credit contraction. 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. Hedging is a strategy by which an investor buys some asset and then sells another related asset short to protect against a downturn in price.
But, like Seth Klarman says, hedging is not always appropriate and can be tricky to maintain. By far the best way to protect your downside, according to Klarman, is to buy with a large margin of safety, and Klarman divotes an entire chapter to it in his book. The need for a large margin of safety should be obvious to most value investors -- but the degree of importance Seth Klarman places on it helps place him firmly in the deep value camp.
While Buffett looks at good companies at fair prices, Klarman demands a large margin of safety 3 :. 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. The bargain element helps to provide a cushion for when things go wrong.
Warren Buffett tries to protect his downside by buying companies with significant competitive advantages to help them keep growing in the future. From an interview with Charlie Rose 4 :. And, when I find a great business I'm happy to hold it According to Klarman, there are really only 3 ways to value a stock: going concern value, liquidation value, and stock market value.
Going concern value is best suited to stable cash generating businesses. The category breaks down further into discounted cash flow and private market value.
Discounted cash flow valuation is well known to value investors, and so are its pitfalls. Klarman, like other value investing gurus, is quite critical of the approach and cautious when using it 3. When he does find a solid stable company, he prefers to develop a range of scenarios that may unfold for the company and the resulting profitability implications.
After deciding on a range of earnings for the company going forward, Seth Klarman is then very cautious about the discount rate he selects. As with everything he does, conservatism is the name of the game 3 :. Depending on the timing and magnitude of the cash flows, even modest differences in the discount rate can have a considerable impact on the present-value calculation.
Private market value is related to Net Present Value and 3 "values businesses based on valuation multiples that sophisticated prudent business people have recently paid to purchase similar businesses. The strategy fails to make meaningful differences between companies within or between industries, multiples vary over time, and sophisticated buyers do not always pay intelligent prices.
But, the biggest problem with the strategy, according to Seth Klarman, is that sophisticated investors end up using discounted cash flow valuation themselves, so investors are relying on their questionable ability to predict the future. Valuation gets much easier as investors shift to liquidation analysis, as analysis can simply come down to crunching numbers. As Klarman writes 3 :. Accordingly, when a stock is selling at a discount to liquidation value per share, a near and near rock-bottom appraisal, it is frequently and attractive investment.
Some of the best investment strategies in existence rely on liquidation value analysis, such as our Pay Daddy net nets and Ultra stocks. Since liquidation value is really a worst-case valuation analysis, most companies are worth much more than liquidation value 3 :.
The assets of a company are typically worth more as part of the going concern than in liquidation, so liquidation value is generally a worst-case assessment. Even when an ongoing business is dismantled, many of its component parts are not actually liquidated but instead or sold intact as operating entities.
There are a number of ways that investors can leverage liquidation value. Net current asset value, or net net value, is one. Investors can get even more conservative by calculating what Klarman calls net net working capital, essentially the same formula but where investors discount the current asset accounts before subtracting all claims prior to the common.
The performance is fantastic 3 :. 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. Another is what Seth Klarman dubs breakup value 3 :. Most announced corporate liquidations are really breakups; ongoing business value is preserved whenever it exceeds liquidation value.
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