Where Most Investors Stumble: Book Notes from Seth Klarman’s “Margin of Safety”

Warren Buffett likes to say that the first rule of investing is “Don’t lose money”, and the second rule is, “Never forget the first rule”.

What is “Risk”?

Risk 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 oil 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?

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.

There are only a few things investors can do to counteract risk: diversify adequately, hedge when appropriate, and invest with a margin of safety. It is precisely because we do not and cannot know all the risks of an investment that we strive to invest at a discount. The bargain element helps to provide a cushion for when things go wrong.

The reality is that past security price volatility does not reliably predict future investment performance (or even future volatility) and therefore is a poor measure of risk.

Margin of Safety

By Seth Klarman

On Mr Market

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. Market’s future movements. 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.

It is vitally important for investors to distinguish stock price fluctuations from underlying business reality. If the general tendency is for buying to beget more buying and selling to precipitate more selling, investors must fight the tendency to capitulate to market forces. You cannot ignore the market — ignoring a source of investment opportunities would obviously be a mistake — but you must think for yourself and not allow the market to direct you. Value in relation to price, not price alone, must determine your investment decisions.

If you look to Mr. Market as a creator of investment opportunities (where price departs from underlying value), you have the makings of a value investor. If you insist on looking to Mr. Market for investment guidance, however, you are probably best advised to hire someone else to manage your money.

As security prices can change for any number of reasons and because it is impossible to know what expectations are reflected in any given price level, investors must look beyond security prices to underlying business value, always comparing the two as part of the investment process.

On Junk Bonds

Unfortunately newly issued junk bonds were not the low-risk instruments that buyers were led to believe. They have, in fact, very different risk and return characteristics from fallen angels. Specifically, newly issued junk bonds offer no margin of safety to investors. Trading around par value, they have very limited appreciation potential, but unlike high-grade bonds trading near par, they have substantial downside risk.

A fallen angel, by contrast, trades considerably below par and thus has less downside risk than newly issued junk bonds of comparable credit quality. The other side of this coin is that bonds trading below par have more upside price potential than bonds trading at par. If underlying credit quality improves or if interest rates drop, discount bonds have room for substantial appreciation; bonds trading at par, by contrast, are usually subject to call prior to maturity and thus have very limited upside potential. Other things being equal, then, newly issued junk bonds carry greater risk of loss with lower potential return than fallen angels, an important distinction that Milken failed to make, at least publicly.

Default rates don’t tell you the whole story

For most of the 1980s the default-rate numerator (the volume of junk-bond defaults occurring in a given year) lagged behind the rapidly growing denominator (the total amount of junk bonds outstanding during that year). It was only when issuance virtually ceased in 1990 that the deterioration in credit quality was reflected in default-rate statistics.

The Infamous EBITDA

It is not clear why investors suddenly came to accept EBITDA as a measure of corporate cash flow. EBIT did not accurately measure the cash flow from a company’s ongoing income stream. Adding back 100 percent of depreciation and amortisation to arrive at EBITDA rendered it even less meaningful. Those who used EBITDA as a cash-flow proxy, for example, either ignored capital expenditures or assumed that businesses would not make any, perhaps believing that plant and equipment do not wear out.

In fact, many leveraged takeovers of the 1980s forecast steadily rising cash flows resulting partly from anticipated sharp reductions in capital expenditures. Yet the reality is that if adequate capital expenditures are not made, a corporation is extremely unlikely to enjoy a steadily increasing cash flow and will instead almost certainly face declining results.

Some analysts and investors adopted the view that it was not necessary to subtract capital expenditures from EBITDA because all the capital expenditures of a business could be financed externally (through lease financing, equipment trusts, nonrecourse debt, etc.). One hundred percent of EBITDA would thus be free pretax cash flow available to service debt; no money would be required for reinvestment in the business. This view was flawed, of course. Leasehold improvements and parts of a machine are not typically financeable for any company. Companies experiencing financial distress, moreover, will have limited access to external financing for any purpose.

An over-leveraged company that has spent its depreciation allowances on debt service may be unable to replace worn-out plant and equipment and eventually be forced into bankruptcy or liquidation.

Junk is junk 

The existence of CBOs was predicated on the receipt of this investment-grade credit rating on the senior tranche. Greedy institutional buyers of the senior tranche earned a handful of basis points above the yield available on other investment-grade securities. As usual these yield pigs sacrificed credit quality for additional current return. The rating agencies performed studies showing that the investment-grade rating was warranted. Predictably these studies used a historical default-rate analysis and neglected to consider the implications of either a prolonged economic downturn or a credit crunch that might virtually eliminate refinancing. Under such circumstances, a great many junk bonds would default; even the senior tranche of a CBO could experience significant capital losses. In other words, a pile of junk is still junk no matter how you stack it.

Contrary to the promises of underwriters, junk bonds were a poor investment. They offered too little return for their substantial risk. To meet contractual interest and principal obligations, the number of things that needed to go right for issuers was high while the margin for error was low.

Although the potential return was several hundred basis points annually in excess of U.S. Treasury securities, the risk involved the possible loss of one’s entire investment.

Why should the history of the junk-bond market in the 1980s interest investors today? If you personally avoided investing in newly issued junk bonds, what difference should it make to you if other investors lost money? The answer is that junk bonds had a pernicious effect on other sectors of the financial markets and on the behavior of most financial-market participants. The overpricing of junk bonds allowed many takeovers to take place at inflated valuations. The excess profits enjoyed by the shareholders of the acquired companies were about equal to the losses eventually experienced by the buyers of this junk.

Cash sunk no matter how you stack it. received by equity investors from junk-bond-financed acquisitions returned to the stock market, bidding up the prices of shares in still independent companies. The market prices of securities involved in arbitrage transactions, exchange offers, and corporate reorganizations were all influenced by the excessive valuations made possible by the junk-bond market. As a result, even those who avoided owning junk bonds found it difficult to escape their influence completely.

Investment Goals

Don’t lose Money! 

Warren Buffett likes to say that the first rule of investing is “Don’t lose money,” and the second rule is, “Never forget the first rule.” I too believe that avoiding loss should be the primary goal of every investor. This does not mean that investors should never incur the risk of any loss at all. Rather “don’t lose money” means that over several years an investment portfolio should not be exposed to appreciable loss of principal.

An investor is more likely to do well by achieving consistently good returns with limited downside risk than by achieving volatile and sometimes even spectacular gains but with considerable risk of principal.

An investor who earns 16 percent annual returns over a decade, for example, will, perhaps surprisingly, end up with more money than an investor who earns 20 percent a year for nine years and then loses 15 percent the tenth year.

Choosing to avoid loss is not a complete investment strategy; it says nothing about what to buy and sell, about which risks are acceptable and which are not. A loss-avoidance strategy does not mean that investors should hold all or even half of their portfolios in U.S. Treasury bills or own sizeable caches of gold bullion. Rather, investors must be aware that the world can change unexpectedly and sometimes dramatically; the future may be very different from the present or recent past. Investors must be prepared for any eventuality.

Rather than targeting a desired rate of return, even an eminently reasonable one, investors should target risk. Treasury bills are the closest thing to a riskless investment; hence the interest rate on Treasury bills is considered the risk-free rate. Since investors always have the option of holding all of their money in T-bills, investments that involve risk should only be made if they hold the promise of considerably higher returns than those available without risk. This does not express an investment preference for T-bills; to the contrary, you would rather be fully invested in superior alternatives. But alternatives with some risk attached are superior only if the return more than fully compensates for the risk.

On Value Investing

Value investing is the discipline of buying securities at a significant discount from their current underlying values and holding them until more of their value is realized. The element of a bar- gain is the key to the process. In the language of value investors, this is referred to as buying a dollar for fifty cents. Value investing combines the conservative analysis of underlying value with the requisite discipline and patience to buy only when a sufficient discount from that value is available. The number of available bargains varies, and the gap between the price and value of any given security can be very narrow or extremely wide.

Sometimes a value investor will review in depth a great many potential investments without finding a single one that is sufficiently attractive. Such persistence is necessary, however, since value is often well hidden.

The disciplined pursuit of bargains makes value investing very much a risk-averse approach. The greatest challenge for value investors is maintaining the required discipline. Being a value investor usually means standing apart from the crowd, challenging conventional wisdom, and opposing the prevailing investment winds. It can be a very lonely undertaking. A value investor may experience poor, even horrendous, performance compared with that of other investors or the market as a whole during prolonged periods of market overvaluation. Yet over the long run the value approach works so successfully that few, if any, advocates of the philosophy ever abandon it.

Be patient… for a value investor a pitch must not only be in the strike zone, it must be in his “sweet spot.” Results will be best when the investor is not pressured to invest prematurely. There may be times when the investor does not lift the bat from his shoulder; the cheapest security in an overvalued market may still be overvalued. You wouldn’t want to settle for an investment offering a safe 10 percent return if you thought it very likely that another offering an equally safe 15 percent return would soon materialize.

The Value Investing Philosophy

Be a Bottom-up investor—don't be fully invested, hold cash, think about the opportunity cost. 

One significant and not necessarily obvious difference between a bottom-up and top- down strategy is the reason for maintaining cash balances at times. Bottom-up investors hold cash when they are unable to find attractive investment opportunities and put cash to work when such opportunities appear. A bottom-up investor chooses to be fully invested only when a diversified portfolio of attractive investments is available. Top-down investors, by contrast, may attempt to time the market, something bottom-up investors do not do. Market timing involves making a judgment about the overall market direction; when top-down investors believe the market will decline, they sell stocks to hold cash, awaiting a more bullish opinion.

Near-term security prices also matter to investors in a troubled company. If a business must raise additional capital in the near term to survive, investors in its securities may have their fate determined, at least in part, by the prevailing market price of the company’s stock and bonds...This line reminds me of First Republic Bank.

Opportunity Cost

If you are fully invested when the market declines, your portfolio will likely drop in value, depriving you of the benefits arising from the opportunity to buy in at lower levels. This creates an opportunity cost, the necessity to forego future opportunities that arise. If what you hold is illiquid or unmarketable, the opportunity cost increases further; the illiquidity precludes your switching to better bargains.

The most important determinant of whether investors will incur opportunity cost is whether or not part of their portfolios is held in cash. Maintaining moderate cash balances or owning securities that periodically throw off appreciable cash is likely to reduce the number of foregone opportunities.

Another way to limit opportunity cost is through hedging. A hedge is an investment that is expected to move in a direction opposite that of another holding so as to cushion any price decline. If the hedge becomes valuable, it can be sold, providing funds to take advantage of newly created opportunities.

In A Nutshell: Where Most Investors Stumble

The primary goal of value investors is to avoid losing money. Three elements of a value-investment strategy make achievement of that goal possible. A bottom-up approach, searching for low-risk bargains one at a time through fundamental analysis, is the surest way I know to avoid losing money. An absolute- performance orientation is consistent with loss avoidance; a relative-performance orientation is not. Finally, paying careful attention to risk — the probability and amount of loss due to permanent value impairments — will help investors avoid losing money. So long as generating portfolio cash inflow is not inconsistent with earning acceptable returns, investors can reduce the opportunity cost resulting from interim price declines even as they achieve their long-term investment goals.