“Margin of Safety” by Seth Klarman

[hendi_alex]

The book is readily available on line. There are links to two different sources provided earlier in this thread.

[Dividend Watcher]

Alex, those links are dead ends now. The downloads are gone. I searched for about 1/2 hour and 1 site mentioned that Google, the "do no harm" company, forced them to take it down with a DMCA Copyright complaint.

Looking forward to Kerim sharing more excerpts and thoughts. <ahem>

[Kerim]

(01-24-2014, 12:54 AM)Dividend Watcher Wrote: Looking forward to Kerim sharing more excerpts and thoughts. <ahem>

Lol. Yes, yes, I've been meaning to get back to that. Now that my work crush is done, I should be able to soon.

[Kerim]

Chapter 6: Value Investing: The Importance of a Margin of Safety

In chapter 6, Klarman still does not yet get to the nuts and bolts of value investing, but he does provide a more in-depth conceptual framework. The chapter opens with a concise and clear definition of value investing:

Quote: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 bargain is the key to the process.

So right off the bat we’ve got a couple of meaty topics for dividend growth investors. First, many DG investors like to buy their shares at as much of a bargain as is possible – this makes perfect sense. But many (including me) also are comfortable buying shares in excellent dividend growth companies at “fair” prices, since these companies are able to grow earnings and dividends over time, and we plan on holding for a very long time. Of course this varies by company. As I’ve mentioned elsewhere, I own both LMT and KO in my portfolio, and I consider them both to be good dividend growth stocks. But I would probably not buy shares in LMT unless it was a true bargain, while I do not demand the same bargain when I buy KO. Second, Klarman clearly contemplates the sale of shares purchased at a discount once they have risen to fair value. Most dividend growth investors seem keen on holding for the income stream, even if share prices rise from the bargain basement to fair value.

Klarman emphasizes the importance of patience and discipline in value investing. He says that a value investor does not worry about being fully invested, and will sit out long periods of overvaluation waiting for the right companies to reach the right prices. “[T]he cheapest security in an overvalued market may still be overvalued,” he writes. Conversely, in periods of market turmoil, there may be opportunities aplenty, and a disciplined value investor will carefully select the very best opportunities.

Klarman devotes several pages to acknowledging that valuing a business is inherently complex, relies on information that cannot be known, and that conditions continually change. He advocates taking a conservative view, assuming the worst to ensure that you’ll never pay more than a great price.

On the importance of the margin of safety, Klarman writes:

Quote:Benjamin Graham understood that an asset or business worth $1 today could be worth 75 cents or $1.25 in the near future. He also understood that he might even be wrong about today's value. Therefore Graham had no interest in paying $1 for $1 of value. There was no advantage in doing so, and losses could result. Graham was only interested in buying at a substantial discount from underlying value. By investing at a discount, he knew that he was unlikely to experience losses. The discount provided a margin of safety.

Klarman concedes that each investor will differ as to the right margin of safety, and that the answer to that question “comes down to how much you can afford to lose.” More tangibly, he suggests that in valuing a company, a value investor should give preference to tangible assets over intangible. And of course, when you are considering an undervalued stock, it is crucial to understand why it is undervalued.

The chapter includes a long section explaining that value investing is predicated on the efficient market hypothesis being wrong. Buried in this section is the gem: “Technical analysis is indeed a waste of time.”

Finally, Klarman warns that the term “value investing” is often mis-used to describe other, less disciplined investing strategies, and that managers claiming to follow a value approach should be carefully scrutinized to ensure that they do indeed.

[Dividend Watcher]

(09-24-2013, 09:45 PM)Kerim Wrote: We've practically got a book club going!

Thanks for continuing, Oprah.

Interesting reading. As I was reading your latest installment, it struck me that one big difference between a value investor and a dividend growth investor is the value investor is more focused on price versus value and a DGI is more focused on the dividend stream and its growth versus value.

For myself, I'm willing to pay a fair (and sometimes even a little overvalued) price for a quality company that offers a reliable dividend stream -- JNJ being my latest example. That's why I try to buy in partial positions at a time -- to guard against my own stupidity building a position.

We all would love to buy everything at a bargain price but there are other factors involved. Age and time available before a DGI would need that dividend stream, for one.

Looking forward to the next installment.

[Kerim]

I agree completely, DW. I was thinking that once I get all the way through the book, it would be great to start a separate thread about DG versus value investing. At a very high level, my hunch is that following a pure value approach as espoused and practiced by Graham, Buffett, and Klarman is a surer way to get mega-rich from stock investing, but that it requires more knowledge, time, capital, and discipline than most folks with jobs and families can devote to investing. A dividend growth approach is much simpler to understand and execute with limited time for research and limited capital. The DG approach is much more forgiving and accessible to most lay-investors.

[Kerim]

Chapter 7: At the Root of a Value-Investment Philosophy

In Chapter 7, Seth Klarman describes the three central elements to a value-investment philosophy. This is generally more high-level stuff, and I am starting to wonder if he is ever going to get around to actually explaining how to identify value situations that present a margin of safely.

First, he says, value investing is a “bottom-up” strategy. Many “investors” use a “top-down” strategy that involves predicting macro-economic trends, determining the investment implications of those predictions, and then deciding which sectors or companies are likely to benefit from those implications. As Klarman frames it, this is an incredibly complicated undertaking with numerous opportunities to be wildly wrong. When you take a bottom-up approach, however,

Quote:individual investment opportunities are identified one at a time through fundamental analysis. Value investors search for bargains security by security, analyzing each situation on its own merits. An investor’s top-down views are considered only insofar as they affect the valuation of securities.

This is a far simpler approach, more amendable to success, that can essentially be described as “buy a bargain and wait.”

Second, value investors must adopt an absolute-performance orientation. The goal must not be to outperform the market generally or other investors. Value investors, Klarman states, are interested in returns only insofar as they relate to the achievement of their own investment goals. While there is some appeal in this position, and I have certainly heard it espoused by many dividend growth investors, I’ve never understood why anyone would want to blind themselves to how their strategy performs relative to, say, broad market index funds. If I knew that my strategy, after a long-enough time period, was underperforming the indexes, I like to think I’d be smart enough to admit that either my strategy or execution was flawed and save a bunch of time and money by switching to index funds. My goal is not specifically to “beat” the index, but if I learned I was consistently trailing it, that would be a strong signal that changes are needed.

Third, value investing is a risk-averse approach in which as much attention is paid to risk (what can go wrong) as to return (what can go right). Klarman cautions that risk and return are not always positively correlated, and that risk is not synonymous with volatility (there is a whole section warning against putting much faith in beta as a measure of a security’s risk).

Quote:In point of fact, 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.

There is a short and interesting section on the nature of risk, in which Klarman explains that risk – defined as the probability and magnitude of an adverse outcome – “is a perception in each investor’s mind” that (unlike return) “is no more quantifiable at the end of an investment than it was at its beginning.” Klarman concludes that there are only a few things that an investor can do to counteract risk: diversify adequately, hedge when appropriate, and invest with a margin of safety.

[Dividend Watcher]

(05-05-2014, 05:50 PM)Kerim Wrote: Value investors, Klarman states, are interested in returns only insofar as they relate to the achievement of their own investment goals. While there is some appeal in this position, and I have certainly heard it espoused by many dividend growth investors, I’ve never understood why anyone would want to blind themselves to how their strategy performs relative to, say, broad market index funds. If I knew that my strategy, after a long-enough time period, was underperforming the indexes, I like to think I’d be smart enough to admit that either my strategy or execution was flawed and save a bunch of time and money by switching to index funds. My goal is not specifically to “beat” the index, but if I learned I was consistently trailing it, that would be a strong signal that changes are needed.

Thanks for continuing ( finally ), Kerim. I bolded what's been driving me lately.

I'm starting to parrot RAS and chowder here but the income stream and its safety has been more and more of my focus lately.

If my portfolio value stopped growing today yet the dividend stream kept growing at 6% a year for the next 20 years, I'd be extremely happy. My income stream has increased about 9% since year-end 2013 in the first 4 months. Part of that was from rebalancing and the rest from all the dividend increases managements keep throwing at me just for being an old fart like BAX did today.

It's like owning an AMC Gremlin versus a Maserati. Both will get you pulled over if you exceed the speed limit but one will only use a cup of gasoline instead of a couple gallons getting there. (OK, that's a metaphor only the geezers amongst us will get. )

Regardless, thanks for sharing again. Interested in hearing the next chapter.

[Kerim]

Just saw that this hard-to-find book is now available on Amazon's Kindle store for $10!

Grab it while you can.

[Dividend Watcher]

(07-10-2018, 08:43 AM)Kerim Wrote: Just saw that this hard-to-find book is now available on Amazon's Kindle store for $10!

Grab it while you can.

Well, let's hope those that wanted it grabbed it cuz ...

Good luck finding it now.

[Kerim]

(07-11-2018, 05:25 PM)Dividend Watcher Wrote:

(07-10-2018, 08:43 AM)Kerim Wrote: Just saw that this hard-to-find book is now available on Amazon's Kindle store for $10!

Grab it while you can.

Well, let's hope those that wanted it grabbed it cuz ...

Good luck finding it now.

Alas!

[Dividend Watcher]

Kerim, I have to admit your summaries piqued my interest and some of the things you brought up I've used in my search for decently valued dividend growth stocks. However, at the time you were commenting about it, the companies I am/was interested in didn't hit the deep value that Seth Klarman was talking about. Those days were over after 2009-11 when finding very undervalued dividend growth companies was like shooting fish in a barrel.

Several articles I've seen since about what Mr. Klarman was holding in his portfolio(s) would not interest me today. That's not to say you couldn't become very wealthy following Mr. Klarman's deep value approach but the time and effort finding, researching and following every twist and turn of the companies' fortunes until the value is realized is not what I have in my plan at this stage in life.