Margin of Safety book is among the most revered value investing books, and for good reasons. Initially published in 1991, Seth Klarman took the term coined by Ben Graham as the title of his book. When it was released there were solely 5,000 copies sold. Today it has become not only a great source of insight on value investing but also a highly collected book.
Margin of Safety: Risk-Averse Value Investing Strategies for Thoughtful Investors
Certainly, during the ’90s and more specifically the late 90s, the last thing investors had on their mind was value investing. The dot-com bubble was the pinnacle of speculation and mania all combined in what Alan Greenspan coined as “irrational exuberance”. The last thing investors had on their mind was risk-averse value investing strategies, during the late 90s the market took the complete opposite approach. Risk-seeking growth investing and went on for a good while.
During the same time, value investors such as Warren Buffett were being questioned on their ability to adapt to this new market reality. This is why Seth Klarman’s book was such a great contrast with what was happening at the time. Perhaps the reason why the book was poorly received at first. As investors dealt with their losses, they turned again to what makes sense, risk-averse value investing.
The basis for Margin of Safety
Seth Klarman says the primary goal of investors should be to avoid losses. They must follow a risk-averse value investing strategy at all costs. The idea is that permanent capital losses could affect your ability to compound your capital over time. By ensuring that the stocks you invest in have a margin of safety, they essentially have a cushion for errors in judgment, analytical mistakes, and extraordinary volatility.
Therefore the only strategy that makes sense is to buy a security for a lower price than its intrinsic value. Looking for undervalued securities becomes then the main concern of value investors.
Investors make mistakes
In the first section of the Margin of Safety book, Seth Klarman goes over the common mistakes investors make. He argues that investors oftentimes rely too much on speculation and that over time their performance is subpar. By shedding light on these common mistakes, the author tries to describe how investors should change their behavior. Explaining the importance of having risk-averse strategies in place.
“Individual and institutional investors alike frequently demonstrate an inability to make long-term investment decisions based on business fundamentals”
This is perhaps one of the most memorable quotes from the Margin of Safety book. It serves as the basis to explain why investors often tend to make mistakes. Their overfocus on the short-term affects their thinking and their investment thesis.
Seth Klarman also presents arguments as to why Wall Street tends to have a negative effect on investors’ thinking. Dubbing Wall Street as the world’s biggest casino. Where investors are lured by the speculative successes of others, and often invest in a way that tries to replicate them.
Margin of Safety book also mentions that this leads to one of the most common investment mistakes - overtrading.
Fear and greed
Seth Klarman also points out how investors are driven by fear and greed. How this fuels their trading ideas, and how it affects their returns. They let their emotions overcome their rational thinking, and speculate instead of investing.
Over-reliance on mathematical formulas
Another important point mentioned in the book is how traders and investors often resort to mathematical formulas to invest and trade. Seth Klarman argues that:
“investment success cannot be captured in a mathematical equation or a computer program”
In fact, trading and investing is as much an art as it is a mathematical field. There are some uses for mathematics in finance, however, when it comes to trading and investing, it is much more than a set of formulas. Markets are complex, and unfortunately, there is no sure formula to capture market participants' emotions.
Wall Street is more concerned with fees
Seth Klarman also mentions an important aspect that every investor and trader should consider. Wall Street is far more concerned with fees, and their commissions than their economic utility. Therefore, their main interest is the higher trading volume that will result in higher fees.
Investors do not know what is speculation and investing
One important point of the book is how investors cannot differentiate between speculation and investing, namely value investing. Therefore most of their actions are more based on emotional reactions than actually rational investment and financial decisions. This leads them to speculate more often than should.
Nobody knows where the market is going
Margin of Safety book also mentions how most market participants are absolutely clueless about where the market is going next. Therefore, it is a futile, and fruitless endeavor to speculate on what the market will do next. Predictions of this nature are clearly a waste of time.
The second section of the book focuses on value investing. Seth Klarman explains in detail the concept and its interpretation. Defining margin of safety as the difference between the intrinsic value of a stock and its current market price.
He explains how investors can take advantage of this, by buying stocks for a far lower price than its value, and then sell it at a higher price, once there is a stock rerate. One of the key arguments made by Klarman is that investors must understand why value investing works. Investors must learn the philosophy of value investing rather than seeking an easy formula-based based strategy that is often difficult to replicate.
Seth Klarman also details how risk should be perceived as the probability of loss in a certain investment.
Buy stocks for less than their intrinsic value
This is what value investing is all about. Buying stocks for a price that is lower than what they are actually worth. Holding value stocks, and waiting for the price to appreciate is the most rational way to invest. Essentially buying a dollar at fifty cents.
Investors need a margin of safety
Investors need a margin of safety. It means investors must buy a security at a significantly lower price than its intrinsic value. The margin of safety is the difference between the intrinsic value, and the price paid. It allows investors to cope with the analysis mistakes, extreme volatility, and human errors.
Value investors need to continuously look for stocks
Another notion that is widely mentioned in the book is that investors must constantly look for new stocks, and investment opportunities. Nothing is certain in the stock market, and constantly researching stocks allows us to compare with our current portfolio.
Applying value Investing
Even when investors learn value investing theory, they fail to apply it. One of the main reasons is the lack of patience. Value investing requires a large amount of patience, and the holding period for certain stocks can sometimes be long. It is a difficult and tenuous process that requires far more than just buying securities at the right price. In order to generate significant returns, you need to hold these securities, in some cases for quite some time.
Investors are too focused on the short-term
Most investors seek short-term and quick gains. This focus on the short-term makes it difficult to conduct value investing because it is a long-term strategy. This means that the holding period will be entirely different depending on the stock you buy.
Value investing is a bottom-up approach that starts with identifying the undervalued securities. Unlike the top-down approach followed by most investors, they try to spot major trends. Value investing focuses on researching individual stocks, and understanding if they are trading under their intrinsic value.
A risk-averse approach ensures that the investor has enough margin of safety. This means that even if the initial analysis had some flaws, or the investor overestimated some assets of the company, there is value there. The larger the difference between price and intrinsic value, the better it will be for investors.
Value investors need to adapt
Another important aspect mentioned in Margin of Safety book is that investors need to be able to adapt. Markets change at a fast pace, and changing your mind about a particular investment is important. Every investor makes mistakes, but being able to identify them, and correct them is among the most important characteristics.
Value investors need to be conservative
Being conservative means that you are valuing the company in a conservative way. Guaranteeing that your margin of safety is not overestimated is another important aspect to consider.
Avoid related diversification
“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”
Overcoming fear and greed
Investors must overcome their emotions of fear and greed. The emotion of fear when prices are falling and the emotion of greed when prices move upwards can lead investors to make wrong investing decisions, driven by FOMO.
Dealing with risk
Investors consider the risks rather than specific returns when they are evaluating a particular stock or investment. They must also be willing to forego some near-term gains. As a margin of safety against the risk of unexpected and unpredictable adverse outcomes.
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