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“Margin of Safety” by Seth Klarman
#1
Dividend growth investing and value investing are natural allies. To the extent that you can apply value investing principles to the selection and purchase of quality dividend growth stocks, you can significantly improve both your odds of success and your returns.

After reading this post from Tim McAleenan about an excellent but lesser-known book about value investing, I was eager to read it. The book is Margin of Safety, written by Seth Klarman and published in 1991. Apparently, this is a very difficult book to get ahold of, but fortunately Tim’s post includes a link to a .pdf copy of the book.

I’m a couple of chapters in and am finding it a truly worthwhile read. I’m going to put up a few short posts here about the thoughts and insights I’m gleaning from the book, starting here with the introduction.

The introduction presents an overview of the book, and invokes Benjamin Graham and Warren Buffet as predecessors and kindred investors. Then there is this description of what value investing is, which includes the origin of the book’s title:

Quote:The focus of most investors differs from that of value investors. Most investors are primarily oriented toward return, how much they can make, and pay little attention to risk, how much they can lose. * * * Value investors, by contrast, have as a primary goal the preservation of their capital. It follows that value investors seek a margin of safety, allowing room for imprecision, bad luck, or analytical error in order to avoid sizable losses over time. A margin of safety is necessary because valuation is an imprecise art, the future is unpredictable, and investors are human and do make mistakes. It is adherence to the concept of a margin of safety that best distinguishes value investors from all others, who are not as concerned about loss.

It has me wondering already if I am generally disciplined enough in my investing approach. And I am really looking forward to re-evaluating the role of stocks such as NLY, FRT, and ARCP in my portfolio. Yes, they juice my annual income stream nicely, but have I evaluated the risks sufficiently?

Chapter 1 is excellent, so I’ll try to post about that soon.
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#2
Thanks for the link. I've heard wonderful things about the book but have never read it. Glad that there is a pdf of it. I'll read it now.
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#3
I've also been working on this book after reading the post by Tim. I've also enjoyed it and am learning a lot. I'm only a few chapters in so far but its really driving home the point to invest in quality and not to overpay for it.
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#4
We've practically got a book club going!
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#5
Chapter 1: Speculators and Unsuccessful Investors

I really love Chapter 1 of this book. It is probably old hat to most of you, and to me even, but it is so well and clearly stated that it feels like new knowledge.

Chapter 1 is devoted to discussion of investment versus speculation. The concept is applied both to people and to investments. With respect to people: Investors are those who compare the price of a security to its underlying value; speculators focus on price alone while trying to predict whether others will pay more for the security in the future. With respect to securities: “investments throw off cash flow for the benefit of the owners; speculations do not. The return to the owners of speculations depends exclusively on the vagaries of the resale market.”

And Chapter 1 contains this old gem:

Quote:Mr. Market stands ready every business day to buy or sell a vast array of securities in virtually limitless quantities at prices that he sets. He provides this valuable service free of charge. Sometimes Mr. Market sets prices at levels where you would neither want to buy nor sell. Frequently, however, he becomes irrational. Sometimes he is optimistic and will pay far more than securities are worth. Other times he is pessimistic, offering to sell securities for considerably less than underlying value. Value investors—who buy at a discount from underlying value—are in a position to take advantage of Mr. Market's irrationality.

Some investors—really speculators—mistakenly look to Mr. Market for investment guidance. They observe him setting a lower price for a security and, unmindful of his irrationality, rush to sell their holdings, ignoring their own assessment of underlying value. Other times they see him raising prices and, trusting his lead, buy in at the higher figure as if he knew more than they. The reality is that Mr. Market knows nothing, being the product of the collective action of thousands of buyers and sellers who themselves are not always motivated by investment fundamentals. Emotional investors and speculators inevitably lose money; investors who take advantage of Mr. Market's periodic irrationality, by contrast, have a good chance of enjoying long-term success.

I like to think that I act pretty rationally in making my stock decisions, but on reading this chapter, if I am honest about it, I can see places where I let speculative thinking take over. Perhaps this hasn’t bitten me badly as yet because I am generally well-anchored with an investing mindset. But I’ll definitely try to be more aware of it going forward.
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#6
I just did a quick search. Found the following site that downloads a much cleaner version to the computer and also allows for downloading to iBooks on my iPad.

http://www.epubbud.com/book.php?g=VY4JVJY8

The regular appearance of 'tossing the baby out with the bathwater' types of opportunities is why IMO it is prudent to always keep 10%-20% opportunity cash on hand, for deploying during the most pessimistic of selling waves.
Alex
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#7
Chapter 2: The Nature of Wall Street Works Against Investors

I’m not going to dwell on Chapter 2 for long, as I think it covers ground pretty well understood by this crowd. The premise of Chapter 2 is that because Wall Street is involved in almost all of your stock investing activities, it is wise to understand its dangers.

While Wall Street performs many important functions, Klarman says, “it frequently is plagued by conflicts of interest and a short-term orientation. Investors need not condemn Wall Street for this as long as they remain aware of it and act with cautious skepticism in any interactions they may have.”

The balance of the chapter is essentially a cautionary tale about watching out for the dangers posed by fees, commissions, conflicts of interest, and the dangerously short-term focus of most Wall Streeters. The chapter also makes some interesting points about the bullish bias of both Wall Street and its regulators. Klarman also devotes some pages to investing fads, concluding that “the stock market frequently attributes a Coca-Cola multiple to a Cabbage Patch concept.”

I was planning to comment that this chapter made the book feel dated, for example it did not anticipate how online brokerages would change fees and retail investor activity. But the further I read, the more I came to appreciate the out-of-date nature as an advantage. It was refreshing and valuable to read examples that pre-dated the dot-com mania and other more recent events that seem to dominate discussion these days.

Favorite quote from the chapter, discussing IPOs:

Quote:Gone are the days (if they ever existed) when a new issue was a collaborative effort in which a business that was long on prospects but short on capital could meet investors with capital in hand but with few good outlets for it. Today the initial public offering market is where hopes and dreams are capitalized at high multiples. Indeed, the underwriting of a new security may well be an overpriced or ill-conceived transaction, frequently involving the shuffling of assets through "financial engineering" rather than the raising of capital to finance a business's internal growth.

Twitter, anyone?
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#8
Chapter 3: The Institutional Performance Derby: The Client Is The Loser

Chapter 3 describes the weaknesses and negative effects of institutional investing. Noting that “institutional investors dominate the financial markets,” author Klarman argues that “[u]nderstanding their behavior is helpful in understanding why certain securities are overvalued while others are bargain priced and may enable investors to identify areas of potential opportunity.”

He then runs down some of the well-known weaknesses associated with managing vast sums of other people’s money: a preference for growing the amount of funds under management that necessarily reduces long-term performance, groupthink, short-term focus, and reliance on relative rather than absolute performance.

My favorite part of the chapter was this:

Quote:Remaining fully invested at all times certainly simplifies the investment task. The investor simply chooses the best available investments. Relative attractiveness becomes the only investment yardstick; no absolute standard is to be met.

* * * * *

Absolute-performance-oriented investors, by contrast, will buy only when investments meet absolute standards of value. They will choose to be fully invested only when available opportunities are both sufficient in number and compelling in attractiveness, preferring to remain less than fully invested when both conditions are not met. In investing, there are times when the best thing to do is nothing at all. Yet institutional money managers are unlikely to adopt this alternative unless most of their competitors are similarly inclined.

This is an important distinction that I never really thought about in so direct a manner. I think I probably think about the value of my prospects in more relative than absolute terms. Not that finding the “relatively” best investments is in itself any small feat, but I’ll have to give more thought to where each investment stands in absolute terms as well.

The chapter is rounded out with a discussion about how many institutional investors have abandoned fundamental stock analysis entirely and with a detailed take-down of indexing as a strategy. Klarman makes some of the better-known arguments against indexing, concluding that “indexing will turn out to be just another Wall Street fad.” I think he may have missed the mark pretty widely there, but nonetheless, some good notions in this chapter.
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#9
Chapter 4: Delusions of Value: The Myths and Misconceptions of Junk Bonds in the 1980s

Chapter 4 is an in depth look at the junk bond debacle of the 1980s. It seems presented mostly as a cautionary tale and as an example of how truly irrational the market can become. I’ve never studied that particular chapter in our financial history, and this chapter is hardly exhaustive. But as I’ve noted before, it is fun to be reading about examples that predate the dot-com craze and the 2008-2009 crisis. Most interesting to me were the many similarities between the junk bond debacle as presented by Klarman and the more recent housing bubble and mortgage-backed securities nightmare.

Like the mortgage-backed securities, the junk bonds “appeared to perform a sort of financial alchemy.” Despite the newness of the product and the poor understanding of it by many (if not most), fat profits induced all of the large firms to create extensive junk bond practices. Then, of course,

Quote:One of the last junk-bond-market innovations was the collateralized bond obligation (CBO). CBOs are diversified investment pools of junk bonds that issue their own securities with the underlying junk bonds as collateral. Several tranches of securities with different seniorities are usually created, each with risk and return characteristics that differ from those of the underlying junk bonds themselves.

What attracted underwriters as well as investors to junk- bond CBOs was that the rating agencies, in a very accommodating decision, gave the senior tranche, usually about 75 percent of the total issue, an investment-grade rating.

Sound familiar?
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#10
Chapter 5: Defining Your Investment Goals

Chapter 5 is a very short chapter that really just sets up the next portion of the book. The chapter only makes a couple of points, which are not really aimed at helping you determine “your” specific investment goals, as the chapter title suggests.

Rather, Klarman argues that loss avoidance should be the primary goal of every investor. This is not to say that investors should park all their cash in the mattress and take no risk whatsoever, but rather that investors need a clear and consistent understanding of how to assess and use risk. On page 86, he writes:

Quote: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.

Teasing the next chapters, Klarman asserts that only value investing properly focuses on the avoidance of loss and assessment of risk.
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