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Seth Klarman’s “Margin of Safety” in one blog post

Margin of Safety, a value investing classic written in 1991, is out of print, sells for more than 2000$ and is one of the most stolen books in libraries. Here are some of my favorite quotes from Seth Klarman.

On Value Investing

“Value investing requires a great deal of hard work, unusually strict discipline, and a long term investment horizon”

“There is nothing esoteric about value investing, it is simply the process of determining the value underlying a security and then buying it at a considerable discount from that value. It is really that simple. The greatest challenge is maintaining the requisite patience and discipline to buy only when prices are attractive”

“If interplanetary visitors landed on Earth and examined the workings of our financial markets and the behavior of financial market participants, they would no doubt question the intelligence of the planet’s inhabitants. Wall street, the financial marketplace where capital is allocated worldwide, is in many ways just a gigantic casino.”

“Most investors are primarily oriented toward return, how much they can make and pay little attention to risk, how much they can lose. On the contrary, value investors have as a primarily goal the preservation of their capital. It follows that value investors seek a margin of safety, allowing room for imprecision, bad luck and errors. It is adherence to the concept of a margin of safety that best distinguishes value investors from all others.”

“ I find value investing to be a stimulating, intellectually challenging, ever changing, and financially rewarding discipline”

Investing vs Speculating

“Investors in a stock expect to profit in at least one of three possible ways: from free cash flow generated by the business, which will be reflected in a higher share price or distributed as dividends, from an increase in the multiple that investors are willing to pay for the business or by a narrowing of the gap between share price and the underlying business value. Speculators, by contrast, buy and sell securities based on whether they believe those securities will next rise or fall in price. Their judgment regarding future price movements is based, not on fundamentals, but on a prediction of the behavior of others.”

“Some speculators look for Mr. Market for investment guidance. The reality is that Mr. Market knows nothing, being the product of the collectible action of thousands of buys and sellers who themselves are not always motivated by investment fundamentals.”

“Unsuccessful investors are dominated by emotions. Rather than responding coolly and rationally to market fluctuations, they respond emotionally with greed and fear.”

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Source:http://www.safalniveshak.com/wp-content/uploads/2013/06/Safal_Niveshak_Investor_Manifesto.png

On Institutional Investors

“Like dogs chasing their own tails, most institutional investors have become locked into a short term, relative performance derby.”

“If the behavior of institutional investors weren’t so terrifying, it might actually be humorous. The prevalent mentality is consensus, groupthink. Acting with the crowd ensures an acceptable mediocrity; acting independently runs the risk of unacceptable underperformance.”

“The flexibility of institutional investors is frequently limited by a self imposed requirement to be fully invested at all times. Many institutions interpret their task as stock picking not market timing. They believe that their clients have made market timing decisions and pay them to fully invest all funds under their management.”

On Analysis

“The problem with intangible assets is that they hold no margin of safety. The most valuable assets of Dr Pepper/Seven up are the formulas that give those soft drinks their flavors. It is these intangible assets that cause Dr.Pepper/Seven up to be valued at high multiples of tangible book value. If something goes wrong tastes change or a competitor makes inroad the margin of safety is quite low. Tangible assets, by contrast, are more precisely valued and therefore provide investors with greater protection from loss. Tangible assets usually have value in alternate uses, thereby providing a margin of safety.”

“The top down investor thus faces the daunting task of predicting the unpredictable more accurately and faster than thousands of other bright people, all of them trying to do the same thing. It is not clear whether top down investing is a greater fool game, in which you win only when someone else overpays, or a greater genius game, winnable at best only by those few who regularly possess superior insight. In either case, it is not an attractive game for risk averse investors. There is no safety of margin in top down investing. It is not even clear whether top down oriented buyers are investors or speculators. “

Risk and Return

“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.”

“Investors must be willing to forego some near term return, if necessary, as an insurance premium against unexpected and unpredictable adversity”

“All an investor can do is follow a consistently disciplined and rigorous approach; over time the returns will come”

The Fallacy of Indexing

“To value investors the concept of indexing is at best silly and at worst quite hazardous. Warren Buffett has observed that “in any sort of a contest — financial, mental or physical — it’s an enormous advantage to have opponents who have been taught that it’s useless to even try.” I believe that over time value investors will outperform the market and that choosing to match it is both lazy and shortsighted.”

“Indexing is a dangerously flawed strategy for several reasons. First, it becomes self-defeating when more and more investors adopt it. Although indexing is predicated on efficient markets, the higher the percentage of all investors who index, the more inefficient the markets become as fewer and fewer investors would be performing research and fundamental analysis.”

On Price Fluctuations

“In addition to the probability of permanent loss attached to an investment, there is also the possibility of interim price fluctuations that are unrelated to underlying value.”

“Many investors consider price fluctuations to be a significant risk: if the price goes down, the investment is seen as risky regardless of the fundamentals. But are temporary price fluctuations really a risk? Not in the way that permanent value impairments are and then only for certain investors in specific situations.”

“It is, of course, not always easy for investors to distinguish temporary price volatility, related to the short-term forces of supply and demand, from price movements related to business fundamentals. The reality may only become apparent after the fact.”

“While investors should obviously try to avoid overpaying for investments or buying into businesses that subsequently decline in value due to deteriorating results, it is not possible to avoid random short-term market volatility. Indeed, investors should expect prices to fluctuate and should not invest in securities if they cannot tolerate some volatility.”

“If you are buying sound value at a discount, do short-term price fluctuations matter? In the long run they do not matter much; value will ultimately be reflected in the price of a security. Indeed, ironically, the long-term investment implication of price fluctuations is in the opposite direction from the near-term market impact.”

Dear reader, if you get your hands on an original copy, hide it well. It might be worth a lot more in a decade.

Georges Boustany

Moat and The First Principle

Einstein did it, Descartes did it, Steve Jobs did it, Elon Musk did it… and many other pillars of our civilization did it. They call it “The first principle”.
In Mathematics, the first principle indicates the starting point of reasoning. It refers to going back to the most basic of fundamentals and starting to think from there. Thinking by one’s self, as if no one else had thought about the issue before. That is how Elon Musk was able to replace NASA’s space shuttle on his own. And how Steve Jobs was able to revolutionize the technology world. And this is how we stopped believing that the Earth is flat.
It is the only way to be truly creative and…. to become a savvy investor.

As in Mathematics, in investment we need to start from the basics. And the most basic endeavor to inquire about is finding the competitive advantage of a company. Or “the Moat” as Warren Buffett likes to call it.

Value investing, as should all investing be, is all about the first principle. First, it requires a margin of safety: an essential feature to limit losses. In fact, very few investing techniques focus on having a margin of safety. For example, technical analysis & proponents of investing by looking at risk/return based on CAPM… do not have such a feature.
Second, it is not a relative investing strategy. The return of a value investor should not be compared to the market. Specially not in the short term. Value investors disregard the market’s view, and some are even contrarians.
In my blog, I like to focus on value investing. For the purity of its philosophy as well as for the discipline it teaches me. I believe it is extremely important to understand it and even more to be able to achieve it.

In this regard, the first principle is critical for value investors; specially for the advocates of Warren Buffett’s philosophy. For Buffett, one of the most important features of a company to buy is to find one with a moat. The moat is essential for the long-term survival of the company and the prosperity of its shareholders. Therefore, as the first principle dictates, forget everything you know about a company and start from scratch. Start by finding the moat.

Some moats are easy to spot. Coca-Cola’s moat for example is its brand name. When I was in Peru, living on an island with a local family on Lake Titicaca, I truly understood the power of branding. On this island, there was no electricity, no kitchen with flowing water and surely no television and advertising. Yet, for the people of the island, having a bottle of Coca-Cola was as important as having a computer. There are many sweet drinks out there. However, due to the power of its brand, a simple water and sugar recipe became as significant as a computer.
Countless have tried to compete with Coca-Cola but all have failed. Not least, the great Richard Branson and his Virgin Cola.
Coca-Cola was founded in 1892, 121 years ago! I can tell you with certainty: although the world is changing at an exponential rate, in 200 years, people will still be drinking Coca-Cola.

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“My host family on lake Titicaca”

Here are some other sources of moat:

– A simple example would come in the form of an exclusive contract that the government grants to a company (electric utilities, cable franchises etc.)
– Access to low costs through patents or superior technologies that its competitors cannot match in the short term. However this moat rarely lasts more than a few years.
– Ability to retain customers because of high switching costs. For example, if a company installs a new software system for all its employees and pays big sums of money to train them to use it, it will be difficult and expensive for it to think about changing its software. Thus, the software company has a moat.
– Barriers to entry due to governmental privileges, licenses, patents copyrights…
– Economies of scale combined with another form of moat. For economies of scale on their own are not worth much. Specially if new competition can arise and steal their market share.
– Extraordinary managers like Steve Jobs. Although this moat will not last for obvious reasons.

Surely, after determining the moat, it is important to confirm it.

There are some ways to do this; we need to look for:

– Constant or growing market share throughout the years
– Pricing power
– High ROIC
– High return on net tangible assets

After having confirmed the moat through the numbers we can focus on price, competition, industry… And only after having a clear idea of where we stand on the company and at what price we would be interested in buying it, can we look at what the market says. This way, we can make sure, it is our view and not the market’s.

Like Descartes said: “We should all doubt everything we can doubt”. Start from the most fundamental aspects and reinvent how things are done. Or at least try to…

This is the only way to be truly creative and to become a savvy investor.

Georges Boustany

Technology and the Value Investor

Technology is the forbidden fruit for value investors. Value investors prefer boring, non-changing industries that are relatively easy to forecast. However, do you know any industry that hasn’t been altered by technology?

No industry is secluded from technology. Technology is everywhere, from supermarkets to utilities. In the past, value investors have invested in newspapers, TV networks, utilities… At the time, they felt like these slow-changing industries could be foreseen to exist for decades. However, today in hindsight, we know this is not the case.

Take for example, the most boring of them all: Newspapers. The newspaper industry is very easy to understand. You have journalists who write articles and then sell them. The largest expenses are salaries and the revenues come from ads in the newspaper. Newspapers have existed for hundred of years under one form or another. However in the 21st century the Internet came, and it changed everything.

Newspapers started to go bankrupt. TV networks faced increasing competition from YouTube and Netflix. Bookstores have been decimated by Amazon and ebay…
Yes, even boring industries have had their share of excitement in the 21st century.

So what now? With technology changing everything, are value investors a dying breed?

Hopefully not. Albeit, value investors will have to recognize the possibility of change and account for it in their investment decisions.

elon

Have you ever seen Iron Man? With its ingenious billionaire superhero Tony Stark that saves the world. He exists in the real world! His name is Elon Musk.
One of Elon Musk’s companies is Tesla. Tesla revolutionized the world with its amazing electric car.

The electric car industry is still in its infancy and would be a good investment for a long-term value investor. I am not talking about investing in Tesla. It would be impossible to know which company will dominate the industry in 15 years. However the industry will need power stations, electric plugs, or any other gadget that an electric car needs…

Like the electric car industry, the natural gas industry is also still in its infancy. Like I discussed in previous posts, China, the Middle East and Europe are all trying to develop their natural gas industries. Technology will surely play a big role. After all they will need pumps, pipelines, chemicals and software… What better time to find undervalued companies that will flourish with their industries.

Even Warren Buffett, who barely uses a computer, is starting to invest in technology. His investments in IBM and solar panels are, in my view, an evolvement to his investment philosophy. His thesis for IBM is that it has been able to retain customers throughout the years like no other company. As for solar energy, it is the long-term contracts that attract him.

These are just ideas, the hard part is finding the right company with an economic moat and a cheap price.

So start before its too late!

Georges Boustany