Margin of Safety

I recently ran into a copy of Seth Klarman's classic, "Margin of Saftey Risk Averse Value Investing Strategies for the Thoughtful Investor". Out of print, they sell for $700 second hand, but copies appear to be going around electronically (Sorry Mr Klarman , but I am sure you would rather people were reading it than not).

This book was written in 1991 and has not been updated since. Nevertheless, I am struck by the timliness of the arguments and insights, especially considering all the extraordinary events that have taken place in the financial markets since then. E.g:

Investment Fads:

"There are countless examples of investor greed in recent fianancial history. Few, however, were as relentless as teh decade-long "reach for yiled" of the 1980s... Known among Wall Streeters as "yield pigs", such indivudual and institutional investors were susceptible to any invstment product that promised a high rate of return. Wall Street responded with gusto, as Wall Street tends to do when there are fees to ear, creating a variety of instruments that promised high current yields."

Short terminism of Wall Street:
"The utter hypocrisy of Wall Street is exemplified by the "equitization" wave of early 1991, whereby overleveraged comanies issued equity and used the proceeds to repay debt. Wall Street collected investment banking and underwriting fees when those companies were acquired in highly leveraged junk-bond financed takeovers and collected large feees again when the debt was replaced with newly underwritten equity."

"Investment bankers in Wall Street firms are constantly creating new types of securities to offer to customers. Occasionally such offerings both solve the financial problems of issuers and meet the needs of investors. In most cases, however, they address only the needs of Wall Street, that is, the generation of fees and commissions."

"Investors must recognize that the early succss of an innocation is not a relaible indicator of its ultimate merit. Both buyers and sellers must believe that they will beneft in the short run, or the innovation will not get off the drawing board; the longer-term consequences of such innovations, however, may not have been considered carefully... Neither cash-hungry issuers nor greedy investors necessarly analyze the performance of each financial-market innovaation under every conceivable economic scenario. What appears to be new and improved today may prove to be flawed or even fallacious tomorrow."

Short-terminism of institutional fund managers:

"Like dogs chasing their own tails, most institutional investors have become locked into a short-term relative-performance derby... Frequent competitive ranking can only reinforce a short-term investment perspective. It is understandably difficult to maintain a long-term view when, faced with the penalties for poor short-term eformance, the long-term view may well be from the unemployment line."

Failure to understand leverage:
"The relaxation of investment standards by junk-bond investors was accompanied by the dangerous misconception that the amount of debt and equity in a company's capital structure junior to one's own investment provided a degree of protection. It was as if the value of a business existed on the liability side rather than on the asset side of its balance sheet. Although it may be superficially reassuring to know that there are investors in a company whose claims are subordinated to your own, this information is of little, if any, value in asessing the merits of your investment."

Failure to understand risk:
"The view that risk is dependent on both the nature of investments and on their market price is very different from that described by beta... [R]isk is a perception in each investor's mind that results from analysis of the probability and amount of potential loss from an investment. If an exploratory well proves to be a dry hole, it is called risky. If a bond defaults or a stock plunges in price, they are called risky. But if the well is a gusher, the bond matures on schedule, and the stock rallies strongly, can we say they weren't risky when the investment was made? Not at all. The point is, in most cases no more is known about the risk of an investment after it is concluded than was known when it was made."

Banks and financial companies:
"Most businesses can exist indefinitely without concern for the prices of their securities as long as they have adequate capital. When additional capital is needed, however, the level of security prices can mean the difference between prosperity, mere viability, and bankruptcy. If, for example, an undercapitalized bank has a high stock price, it can issue more shares and become adequately capitalized, a form of self-fulfilling prophecy. The stock market says there is no problem, so there is no problem. Ine early 1991, for example, Citicorp stock traded in the teens and the company was able to find buyers for newly issued securities. If its stock price had been in the low single digits, however, it would have been unable to raise additional equity capital, which could have resulted in its eventual failure. This is another, albeit negative form of self-fulfilling prophecy, whereby the financial markets' perception of the viability of a business influences the outcome."

Forecasting
"Some sources of earnings growth are more predictable than others. Growth tied to population increases is considerably more certain than growth stemming from changes in consumer behaviour... On the whole, it is far easier to identify the possible sources of growth for a business than to forecast how much growth will actually materialise and how it will affect profits."